Episode #200: Radio Show: Decade End Returns and Valuations…Process vs. Performance…VC Power Laws
Guest: Episode 200 has no guest but is co-hosted by Justin Bosch.
Date Recorded: 02/03/2020
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Summary: Episode 200 has a radio show format. We cover a variety of topics, including:
- Coronavirus – how investors should be thinking about shocks
- CalPERS firing managers
- Venture capital and power laws
- Knowing what you own
There’s this and plenty more in episode 200.
Links from the Episode:
- 0:40 – Sponsor: AcreTrader
- 1:34 – Intro
- 2:22 – Welcome to the show
- 3:47 – Latest on the Coronavirus
- 8:02 – Protecting your portfolio from shocks
- 13:15 – Valuations around the globe during the financial crisis
- 15:42 – There’s a World of Dividend Stocks Out There. And They Pay More Than U.S. Companies (Barrons)
- 17:45 – Global expectations for markets vs Meb’s outlook over the next decade
- 25:17 – Why do people avoid large allocations to trend following?
- 26:55 – The Fund That Does a Lot by Doing Nothing (Zweig)
- 31:45 – Sponsor: AcreTrader
- 32:55 – VC investing and the importance of power laws
- 34:52 – Chris Mayer 100 Baggers: Stocks That Return 100-to-1 and How To Find Them (Mayer) and The Meb Faber Show – Episode #165: Chris Mayer, “I Do Think The Biggest Challenge…Is Keeping It, Holding On To It”
- 36:43 – The Meb Faber Show – Episode #69: “This is a Little, Secret Way… A Dark Art of Becoming Truly Wealthy… Massive Wealth”
- 37:34 – The Meb Faber Show – Episode #90: “The Crown Jewel of the Alternative Universe is Private Equity”
- 40:35 – Investing in Africa
- 45:04 – The problem with indexing
- 48:19 – Listener question: Finding inefficiencies in the options markets
- 50:01 – Listener question: Highest Sharpe Ratio strategy
Transcript of Episode 200:
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
Sponsor Message: Today’s podcast is sponsored by AcreTrader. You’ve heard me talk about farmland investing for years. It’s an attractive asset class with strong, stable, and non-correlated returns. Not only that, it can serve as a hedge against much of your portfolio. There’s always been a disconnect though. Investors are left with a question. “How do I actually invest in farmland?” Now there’s AcreTrader, where you can invest in shares of farmland in just minutes online. I interviewed AcreTrader founder, Carter Malloy, in Episode 186 back in November. We talked about his professional investing history, the evolution of AcreTrader, and the strenuous diligence process to underwrite each farm offering. Importantly, investing in farmland on AcreTrader is easy because they take care of all the details, from managing farmers and administration, to insurance and payments. AcreTrader takes care of the hassle, so you can sit back and watch your money grow. Go to acretrader.com/Meb to learn more.
Hey, podcast listeners. Today we have a radio show, which should be in the aftermath of Super Bowl national holiday. In today’s episode, we discuss some perspective on the coronavirus and the impact external shocks should realistically have on your investing process. We then spend some time on the decade in market returns, stock market valuations, big institutions like CalPERS firing all their emerging market managers, how everybody says they evaluate managers and strategies based on process, not performance, but then sell those investments based on performance, not process, and the bias that still exists in the investment strategy implementation. We get into VC investing, how power laws dominate everything in that asset class as well as public stocks, and then stay tuned to the end to hear us talk about indexing, and some of the dangers that exist for investors who don’t know what they own. Please enjoy today’s episode. Justin Bosh, welcome.
Justin: Howdy. How’s it going, Meb?
Meb: You know, I’m conflicted. The Chiefs won the great game, I’m an AFC West guy with the Broncos and a lot of people say you aren’t supposed to cheer for your division rivals, but I was cheering for the Chiefs. I have a hard time not cheering for, even though they were favourites, I’d say the underdog just because they haven’t won in 50 years. But it was a fun game.
Justin: It was. It was.
Meb: I faced some basic economic 101 lessons when I was trying to cook a dish that a fellow tweep, Twitter friend, Tren Griffin had recommended. It was actually a restaurant I’ve been to, a famous Thai place that I think started in Portland, has an outpost in New York City, won a bunch of James Beard awards, which is Pok Pok. And they used to have a pop-up in LA. Anyway, they had some wings that I was going to make which is kind of a fish sauce style Vietnamese wings. I spent the time to make the actual marinade and then, sure enough, went to the store and wings sold out.
Justin: No, no.
Meb: No wings from anywhere else so I think we’re going to try to make some sort of udon or something else tonight with the marinade. Can’t let it go to waste. But otherwise it was a fun game.
Justin: Yeah. Great game. A lot of fun. And we’ve… you know, we’re kicking off a brand new year, brand new decade.
Meb: I know, man, it’s finally easing in. You’ve been doing some travel. How many virus masks did you see on your various aeroplanes?
Justin: Not as many as I expected. Not as many as I expected. I expected to see as many… you know, plenty, but probably about the same as normal, maybe a little bit more than average, about a handful of people, that’s it.
Meb: We’re also domestic so I figured if you walk down to the Tom Bradley, which I wouldn’t, because it’s always chaos there, but the International Terminal LAX is probably like half, I would imagine.
Justin: Yeah, you’re probably right there. It’s a scary one. So it’s, but, you know, fascinating to watch the reaction of markets and, you know, today talking with a coworker about how severely the Chinese market is selling off. But it almost seems like we’re kind of business as usual again here in the U.S.
Meb: You know, if you could look back over the past decade or a couple of decades of what is in the popular news flow, if you look at equity returns historically, I mean, my God, look at the things that happened in the 20th century whether it’s been two world wars, even through the U.S. with various currency regimes, with Vietnam, with, I mean, one thing after another, every year it’s something and this kind of goes back in my mind to the old perspective we talk about when we talk about what matters in investing. And so, look, is coronavirus scary? Absolutely. Because it’s uncertain, it’s very dramatic, you see pictures out of China, which isn’t the most transparent country about, you know, the cranes building the 1000 person hospitals from scratch in, like, seven days, and you hear a lot of scary stuff and it is scary.
I mean, look, virus and people getting sick and dying, I mean, think about all the movies we’ve seen, “Pandemic” and all these outbreak sort of movies. I was a biotech guy, and it certainly is scary, but you got to put it into perspective. So, you know, when you think of something relative to say just the flu. And the flu, I had to look this up because I had to broadcast, but so coronavirus has killed about 500 people total so far that we know of, but even if you add another 0, the flu kills almost 50,000 people in the U.S. per year.
Justin: Okay, that’s really, really important perspective.
Meb: Yeah, you know, and so you think about a lot of things. And this goes back to the old…. I mean, look, and there have been times that flu is terrible, the 1918 epidemic, which was something like a third of the world got infected and something like 50,000,000 people died across the world, I think. But even then, you know, I think that the numbers in the U.S. were maybe only half a million or a million, but that was before a lot of people were getting vaccinated, worse sanitation, obviously much less information anyway. And the point being is that when you put it in perspective relative to just the flu that everyone gets and doesn’t get vaccinated against, it gives you a chance to step back and say, “Okay, that’s worth knowing.” That having been said, you know, I think it’s always the things that scare us, that the Bill Gates example that we used to always give in the presentations we talked about in the podcast of, you know, what kills the most people per year.
And the things that everyone’s scared about is snakes and lions and tigers and alligators and reality in order it was like, I believe number one was obviously mosquitoes, number two is other people. Somewhere in the top five was man’s best friend, you know, dog, like, just things no one is afraid of. So the analogy we always give in markets is the things that people are afraid of whether it’s coronavirus, elections, geopolitical, blah, blah, blah, doesn’t really matter relative to doing dumb stuff, paying too much in fees, doing ill-advised tax remove, have very suboptimally weighted portfolios, yada yada, on and on. So anyway, as anything, it’s always worth being mindful of, but there’s plenty of things that are far more important in the long run.
Justin: Yeah, and that ties into a lot of actually points I want to hit today. It brings up to me a good opportunity to sit back and think about a couple of ways to play this. These are always good opportunities to look around and see, “Okay, what’s moving? What’s not?” And remind ourselves A, are we the kind of investor that’s built to take advantage of those things or is that our strategy? And B, if not, is it something that we should look at these and say, “Okay, I’m glad I know what’s going on, it doesn’t impact my strategy at all.” Or are there ways to take advantage of it? How can people A, kind of think about this in terms of their investment strategy? And B, you know, are there ways that we can build our… I mean, these are obviously events that we can’t foresee. We can’t sit around at the end of 2019 or earlier and say, “Hey, in 2020, we’re going to be scared by some virus that pops up out of XYZ country.” What are the ways people can sort of protect themselves from things like this?
Meb: So the first is to understand history and have a little perspective. You know, I think that’s paramount, and we’re going to touch on this in a future podcast we’re going to record called “The Case for Global Investing.” But in general, understanding what’s happened in the past, I mean, my God, you could look back at event scenarios across almost every possible world event over the past 120 years and see how equities responded in various, not just geopolitical, but economic environments. And it started to tease out at least some baseline ideas and then how things would have played out. Most everyone thinks in terms of days, weeks, months, quarters, without looking out to the timeframe of even years but decades. And so if you look at this last decade, you know, returns were pretty spectacular, not just in the U.S., but for a lot of asset classes.
But the U.S. stocks was really the big winner. I was looking at a chart from December ’09 to December 2019 from Leuthold and U.S. stocks did 13.6% per year. And we talked about this on Twitter. And if you look at sectors, I think the best performing sector, not surprising was tech, consumer discretionary right up there, both printing around 17% per year. Also not surprising, the worst energy down around 3% per year, but also, you know, foreign stocks only did six, emerging only four, commodities, the big stinker, -5 per year on the aggregate were almost 4% per year. But that’s a mix of corporates and treasuries as well. So big standout from U.S. stocks. And the thing is, we look back and look forward, you know, I said this on Twitter, but I asked something along the lines of, I was like, “Hey, as we look back over the past 20 years, what was actually the best performing asset class?”
And it was a poll, and the four choices were U.S. stocks, gold, emerging markets, and real estate. And when I finally answered and retweeted it, I think there was a couple of thousand responses and it’s changed since because I gave away the answer, but the number one response was that U.S. stocks were the best performer over the last 20 years, when in reality, they were the worst. Of those four assets, rates, emerging markets, gold, and U.S. stocks, U.S. stocks were the worst performer. And why do people think that is because they extrapolate the recent past, and it’s not even that recent, the last 10 years, the 2000 to 2009 was really the mirror image in a lot of ways of 2009 to 2019. So it’s really easy for people to get sucked in and have this very sort of myopic vision of what happened recently to what happens in the future. But these outsize return years and decades, like, this is normal for markets to be really volatile.
The U.S. market did, I think, 30% last year, and I was laughing, because if someone had compiled all of the forecasts for U.S. stocks for next year, and they all ranged, I mean, these were everyone, ranged from 10%, all the way down to minus 4%. And the funny thing is, I said, “I could beat all of these strategists with one simple idea, which would be, I actually forecast that U.S. stocks will do better than 10 or less than -4,” which is, you know, outside the range of everyone else, because it’s actually pretty rare that the returns fall in that range. It only happens one in five years. So even if you just picked one and said, “All right, I’m gonna just forecast every year they’ll be greater than 10 or less than 4,” you would do better than the forecasters because 4 out of 5 years, it ends up in that range. And so you have these returns that are highly volatile over different market periods, and the short term often is the opposite of long term. So if we look back, you asked me to do this. And so I think it’s a great framework of we’ve been following these CAPE ratios for a long time, you look at countries back in 2009, you know, the country valuations look a lot different than today. It’s hard to remember. What were you doing in 2009? Do you remember? Post financial crisis?
Justin: No, I was in school I think. I was chipping away at getting a handle on how the world works.
Meb: Well, the world was falling apart at that time. So as people were freaking about coronavirus, people were thinking about the entire financial system ending. But I’ll tell you what was broadly similar is that valuations across the board weren’t too crazy different than they are today, if you’re looking at… this is end of year 2009. So the U.S. was trading at a CAPE ratio of 20, although it bottomed out at a CAPE of 13 in March. So downright cheap in the bottom of the financial crisis. And that’s just the end of month, intramonth it would have been a little bit lower. So low teens. But yet some other really cheap countries, so I’m just going down the list, just picking a few out. A lot of Europe, so Belgium was eight, Finland nine, Greece, Ireland, Ireland I think was the lowest at four, Russia was at nine, and then out of the most expensive let’s see what we got. We have Columbia. That’s a famous one I used to talk about a lot on the podcast because I said I got invited to go speak in Colombia in Bogota, and told them their stock market was expensive and they haven’t invited me back. I was very unpopular. It was trading at 38.
Let’s see what else we got here, India 27, Peru 32, China at 29. And those were…a lot of the emerging markets already started to get pummelled over the prior two years. I think they peaked around in ’07, ’08, but India and China were up around PE ratios of 40 to 60. Anyway, most everything else, most of the time spins the normal experience sort of in that, let’s call it 14 to 25 range, right, of just sort of normal valuations. We’ll fast forward 10 years, you had a lot of countries that had a pretty dramatic experience over the past 10 years. So you had Belgium whose CAPE ratio went from 8 to 24, so it’s a straight-up tripling of the CAPE ratio. You have others like Chile and China got cut in half, Colombia, also I mentioned was at 38 now it’s at 16. Czech Republic got cut in half, and so a lot of these as you recall, this becomes a huge tailwind or headwind for stock price appreciation.
So you had…where’s Ireland? Ireland, which, if you remember, was the poster child of just economic collapse, probably with Iceland as well, but they’ve also had a monster run where their CAPE ratio has gone up like 10X or something over the past decade. Who else have we got here? Most of these if you look on the list, there’s a pretty wide dispersion, which is actually pretty fascinating where a lot of these countries some got cut in half, some doubled. The U.S., of course, famously went from 20 to 30, but the UK didn’t do anything, diddly squat, which is probably why “Parents” posted an article this past weekend showing the top dividend-yielding countries in the world and I think numero uno was Czech Republic. Though it’s not really fair because there’s only like 10 stocks in their liquid universe. UK was number two, although oddly enough, they left out countries like Russia and other countries that would have had a much higher dividend yield.
Anyway, you could have done the same experience with dividend yields and it would have given you the same results. Turkey got cut in half. Who else did anything? Switzerland doubled almost 60%. Anyway, there’s a pretty wide dispersion and it just goes to show, you know, that times change. Things look different. And extrapolating on any one year into the future, and we’ll touch on this in “The Case for Global Investing” pod, is a mistake, but it also applies to all the assets not just U.S. stocks, but commodities and real estate and bonds. And so as you take a step back, we’ve ad nauseam talked about valuations here in the U.S. and everywhere, you also get a lot of the year-end, decade-end outlooks. And so I read probably about 20 and they all tend to say the same thing. They add a couple of spices each year.
This year yield curve was very popular amongst some other things, but a lot of them come up with a pretty similar outlook for the world and Vanguard was the one that people love to quote because they tend to be fairly sober but optimistic. And they said for expectations over the next decade, globally diversified portfolio 4.9%, you know, which is better than your Bank of America account, but not the 10% a lot of people expect, which is where everyone tends to cluster and anchor on that number, you know, on the average pension fund down around 7% or 8%, or 6.5% if its corporate pension fund. So expectations often are quite a bit loftier than the outlook from a lot of quant shops. Anyway, that’s a long-winded answer in answering your question, but I think it’s always useful time at year end to reflect on what’s going on in the world and in your portfolio and everything else.
Justin: Yeah. And thinking about process. I mean, you talked about valuations, I mean, that in itself can be a process to run a portfolio based on value investing and it gives you some insight into where we are today and potentially what we might see in the future. And I want to say there continues to be, and you talk about it a lot, a huge disconnect between what the average investor expects and what kind of some of the more sober or even expectations you might have, Meb, going through your process about what the next decade might look like.
Meb: Everyone talks about process and performance. They say, “This is our process for selecting managers.” You don’t hear people talk a lot about process when they’re selling, however. And let me give you an example. Someone allocates to a manager a fund, they had all the process, they run through all their DDQ, they almost never state what their process for then removing that manager is. The main reason they remove them is because they’re underperforming. And if it’s a strategy or an asset class, that’s probably often the exact opposite time that you want to actually be doing it. And so you almost never hear someone… We had someone call us once and say this. They said, “Meb, I just don’t understand. Your fund is doing so much better than I expected. I’m concerned,” you know, most people it’s only “Hey, your fund’s not doing whatever my expectations were so I’m concerned.” But no one gets upset when things are doing well.
And so, the process part of it almost always on the sale side is performance-based. So ask yourself, listeners, if you have a fund or a stock or an allocation, this is a great exercise, is when you buy it write down what your sell criteria is. And if it’s simply outperformance, realise that most asset classes and strategies can go well over 10 years underperforming their historical sort of return targets or generating any alpha. So if it’s simply a performance-based sell, at least state it ahead of time. But in reality, for the most part, you know, I’m interested in things that have done terrible. I want to be allocating more to the asset classes that have a terrible 3, 5, 10-year track record. Now, the caveat on all of this is I’m not spending a lot of time allocating to discretionary managers. And that’s a whole ‘nother ball of wax and so much harder, because that’s a moving target. And, my God, I’m a quant and thank the Lord because I don’t envy the allocators that are allocating to discretionary people.
Because you don’t know what has changed, you know, whether that manager’s gotten a divorce, whether they’ve had a death in the family, whether there’s content in their wealth, whether they’re gravitating more towards macro when they should be a stock picker, and that’s a really hard thing. It’s much easier to just say, “Hey, are emerging markets out of favour for the past 10 years?” But tying this all back into what you talked about in the beginning, is that having respect for history and expectations, but also on the fundamental side and the valuations that at least gives you a common sense anchor to which to make judgments from. So most of the time assets have been most of the time reasonably valued, but there’s times when things go crazy.
There was times when the U.S. traded at a 45 PE in ’99, and Japan at 100 in the ’80s. And so there’s other times when things get down to the single digits, you know, Russia is still trading a single-digit CAPE ratio despite the fact it’s outperforming the U.S. stock market over the last five years. Anyway, at least gives you a guideline. Otherwise, you’re flying blind, and flying blind is really dangerous because then people, you know, things like the coronavirus or news flow is scary because you don’t know how it should be affecting what’s going on in the world. Long-winded answer for you.
Justin: No, no. All good. So I want to shift gears just a bit. You read an investment banking piece that talked about trend following weights and that being they had a big range here, about north of 50%. So talk to…
Meb: This was in…
Justin: Yeah. Walk us through it. Walk us through it.
Meb: This ties in to what we’re talking about and which is, you know, people… Even if you have a system, a human has to design that system in the first place. And so almost everyone wants to implement or institute their own biases. So in this example, it was an investment bank, wrote a piece, I think it was Goldman. But I don’t want to throw them under the bus if it wasn’t, but I think it was Goldman. And they were running a study that’s… and I’ve seen this a 1000 times over in other studies and people writing and it’s the same exact mindset, which is so weird, is if you come up with, like, the old school Markowitz mean-variance optimiser saying what’s the best way to combine these 4, these 10, these 100 assets or strategies, right?
And it’s stocks, bonds, real estate, but at times, they’ll throw in active strategies like trend following and you can come up with all sorts of different trend following indexes, that I think the SocGen is the most famous and say, “How would it fit in?” And the problem, and we’ve talked about this, if you are an evidence-based investor, is that because trend following is so uncorrelated to a traditional portfolio, and if you were to blind the actual subjects and the actual inputs, it almost always spits out an enormous number that you should be allocating to trend following. But how many investors and allocators, CalPERS, all these other big endowments, how many of them do you know that allocate a huge portion to trend following? Well, almost none.
And so the funny part about this paper as I was reading it, and I’ve read this style of paper before, there’s a spit out an optimal way to trend following was 50% to 89%, which is most, if not all of your portfolio. But they concluded that that exercise led to an unrealistically large, optimal weight, so then they must constrain it. Which defeats the whole purpose of doing it in the first place in my mind, you know, and so investors, they often follow models that are only in agreement with their prior beliefs. And so it’s too much career risk, and it’s too uncomfortable to allocate that much to trend following. We do it and the Trinity Portfolios is half. And we’re probably the largest outlier of anyone I know that allocates that much to trend, and I feel like this last decade tying it back to the expectations and returns, you know, as far as trend following, it hasn’t been a huge outlier standout anytime the U.S. equities are romping at 14% a year.
It’s hard to compare with anything and really nothing did this past decade, but trend following in general, and there’s 1,000,000 different flavours, of course, but it wasn’t a huge standout, but the prior decade it was. It did great in 2000 to 2009. So anyway, it’s just an interesting framework if you think about how people go about building portfolios, because you’ll see a lot of these committees and institutions that manage hundreds of billions of dollars talk about these rigorous reports, and then if you look at the footnotes, they say, “Oh no, actually we had to constrain trend following to 5% because otherwise, that’s unrealistic.” Despite the fact that all market cap weighting is trend following anyway, it’s something that’s you got to be careful of, because it ends up changing the entire point of the process. So you have this false insecurity of, “Hey, we did this really interesting study. But if you’re not going to agree with the results, then it’s sort of useless in the first place.”
Justin: So what do you think the hang-up is with large allocations to trend following? Because is it just something that is unpopular and too different? Because it seems odd that, you know, there’s a lot of things I could… I mean, you’ve talked a lot in the past about how, you know, you bake in inflation and drawdowns and there are many, many asset clauses that are extremely risky when you kind of, you know, peel back the onion.
Meb: Yeah, I mean, I think it’s everything we’ve talked about. It’s different, it’s uncomfortable, I mean, I think for the same reason other strategies like concentrated value investing are hard, no one really wants to do it the way that it needs to be done to look different enough so people are kind of okay with this closet and that people don’t like looking too different. They also don’t like the simplicity and the probably sure, stone-cold objectivity of it and that you’re just kind of leaving it up to… If you ever hear anyone interview Dave Harding from Winton about trend following on, like, CNBC, it’s like the most frustrating interview ever because they keep asking like, “So what do you think about gold?” And he’s like, “I don’t think about it, like, I don’t have any, you know, I don’t have any… You know the models say whatever they say.” And this goes on for like 20 minutes and it just doesn’t fit the narrative of fitting in the “What’s going on in the world?”
There was a funny example of sort of just do nothingness, which is something that I feel like is really hard to do in the markets. Going back to the coronavirus, you know, Jason Zweig, one of our favourite writers at The Journal had wrote a post about a mutual fund called the Voya Corporate Leaders Trust that hasn’t made a major change in its portfolio since 1935. And you heard that right, listeners, it’s been almost 100 years. And it’s so funny. He wrote about this at the end of the year, but it was launched 1935 November 18th, and its charter was to hold identical number of shares in 30 stocks. They would never buy new holdings or sell out the existing ones unless a company went bankrupt, underwent a merger or became inadvisable to keep. So basically, it’s like frozen in time and it’s actually hard to go back and find the performance but certainly, since 1970, that actually outperformed the S&P 500 which is pretty funny because it doesn’t even have a portfolio manager.
And if you look at some of the early holdings, you know, some went to zero, so Pennsylvania Railroad, and what is now Sears are essentially worthless, but others like GE did well for a long time, then kind of have fallen out of grace. But it also ended up owning Berkshire and some other companies that did really well. Union Carbide morphed into Linde plc, etc., etc. So it’s still got 22 stocks and amazingly has almost a billion in assets, 59 basis points, you know, it doesn’t own any tech or healthcare, not surprisingly because those weren’t huge markets almost 100 years ago. But it’s funny, like, this is the actual literal implementation of the coffee can portfolio which is something that talks about investing and just putting it away forever. And Bogle, Zweig channelled Bogle, he said when they talk about it, you know, he said, individual ventures to buy equal amount of a couple of dozen stocks and then just put them away for a lifetime because the theory some will go to zero, but a few would turn out to be really monster winners.
And the challenge is that latter part of being able to hold the winners, and this goes back to the power laws of investing where you own an index, it’s guaranteed to own the big winners. But if you do it where you’re buying individual names, the challenge is selling those winners as they become the 5, 10, 50,100, 1000 baggers. Private equity has a hack that does it by, you can’t sell it because private equity VC managers you have to hold for the life of the fund, which is traditionally 10 years. And so that’s a nice way around it because how many people would have sold, you know, the Amazon is a great example you put in 10 grand, it’s now worth $10 million or something like that, but would have sold during a 95% drawdown or the next 50% drawdown, or would have sold on the way up when it doubled or tripled or quadrupled. “My God, I just quadrupled my money. I’m brilliant.”
But in reality, that quadruple is on the way from 10x, 50x, 100x, etc. So, you know, a lot of the whole process of investing in my mind is setting it up for public markets, setting up all your rules, all your ideas, all your allocations ahead of time, and just put that baby on autopilot. I’m updating my annual piece about what I invest in, and public markets, my belief is that you want to treat it almost as if it’s a bank account, or as a bank account, where you’re just investing in whatever you’re investing in, and then you should spend essentially zero time on it and let the funds that you pick do the updating for you.
So if you are a value person, great, have the value trade. If you’re a trend person, let the trend funds do the trading. And in my mind, it’s so much of a better mindset and of all the time and worry and fear spent mucking around with a portfolio. So that was kind of a long windy answer to what you were talking about, but I think so many individuals and institutions, whether it’s talking about the CalPERS or some of those ideas, it’s just a never-ending temptation to muck around. And that’s really easy to do. So anyway, as you think about the next year, the next decade, think in terms of the next 10 years. You know, is it something you can set up your allocation? Would you be okay Rip Van Winkling it and going away for 10 years? Many would probably say they would but then, of course, they wouldn’t in real life.
Justin: Well, no, I appreciate that insight. And one of the most important… I mean, well, for me a really important takeaway, and, you know, you hear this from trend followers a lot, because I think it’s kind of built into the DNA of those types of investors is letting your winners run is really, really hard to do. Especially for, you know, folks who are value investors. I mean, the last thing you want to do is be, you know, holding overvalued stocks and things of that nature. So it’s, you know, you kind of have two opposite ends of the spectrum when you’re thinking about those two types of investors. But that’s one of the more important lessons I’ve learnt over the last several years. And it also ties in really nicely to that concept of VC investing, which I want to get into.
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Justin: You’ve talking recently on the podcast with some founders and some VC investors. And let’s get into that in a little bit of detail. What to you is the really attractive part of VC as an asset class? And then I want to get into the details of the importance of power loss.
Meb: You hit the nail on the head on this comment about letting your winners run. And this has been around for forever in markets, you know, where you have this concept of allowing the big time winners to really make a difference. And eventually they make a huge difference. And if you look at there’s so many, if you read all these personal finance books on millionaires, and they talk about, you know, “Hey, here’s this plumber, or janitor that built up a $5 million fortune while making 20 grand a year, because they would buy stocks and just buy a little more and just forget about them. And then 40 years later, turned out that they had this massive account where 2 or 3 of the stocks were 98% of the account because the other 10 or 20 didn’t do anything but the big ones were monster winners, and they never touched them.”
And so how do you set it up so that you give them room to breathe? And trend followers have a way to do that, because they have objective rules. They’ll sell it when it goes below its long term trend. So you’ll have markets that will go many, many years in a trend one way or the other. You know, and it’s so… a pretty reason example, U.S. stocks have been trending up for a long time and commodities has been trending down. You haven’t had to do a whole lot if you’re trading agriculture, equities or commodities, because they’ve just continued to go to the floor and same thing with energy. But the VCs have a way of doing it because they’re private companies and they can’t trade them. You literally, you can’t, I mean, there’s some secondary markets now that if you want to invest in companies that are probably in the hundreds of millions and up to maybe 5, 10, 20 billion range, you can see the old EquityZen ones we talked about and the like and so their hack is just you let the winners ride because you don’t have a choice.
But the old Chris Meyer book and podcasts we talked about where, you know, he profiled 100 bagger stocks, most of these take 10 years plus, you know, the fastest that anyone’s ever done a 100 bagger, I think might have been, like, Monster Beverage, which did it in like 4 years. But that’s still a pretty long time for most people. So, you know, VC as an asset class, you know, I think it’s tough because in private equity in general, and let’s distinguish between the two. People say private equity, and they often mean both late-stage buyout, which is what private equity kind of describes, and then also early-stage venture capital. And these are under the general asset class of equities. They’re not a separate asset class, but they’re a strategy within the asset class of owning businesses.
And if you look at the most successful, there was a couple other stats I wanted to mention at one point, if you look at a lot of the most successful allocations and so our bud, Sam Rowe [SP], had tweeted this out about, you know, the top portfolios, the highest net worth people and, of course, it’s very heavy in equities. And then there was another one on the family offices where the average wealth is 1 billion, and how they allocate their assets. And of course, they own a huge chunk in equities. They also own quite a bit and in real assets in both cases where it’s real estate, which really is a business that just happens to be a house or commercial property or owning businesses you can then rent out. But that’s essentially a business as well.
Anyway, so private equity and venture capital, you gotta distinguish the two because venture capital and angel investing is really investing in startups. And that is an area that they understand the power law dynamics probably more than anyone, where, if you invest in 30, 50 companies, it’s like 1 or 2 will determine your return. Another podcast guest Jason Calacanis had mentioned that in over, he said 200 companies he’s invested in, 3 accounted for like 98%. And that’s a great example, one of them being Uber, which is probably at this point, a 1000 or 10,000 bagger, but it’s had how a lot of delusion, so I don’t know where it would be, but it’s certainly over 100 bagger. So they understand that. Now, the challenge as the investor standpoint is, you know, if you’re an institution doing this through funds, can you identify the talent ahead of time? Does the asset class change? And I think the answer to a lot of those is it’s complicated with the private equity side. I think that research is getting more, and more, and more, and more in favour of the fact that you can replicate the late-stage leveraged buyouts with public equities.
And there’s been about a dozen academic papers on the topic. We’ve had Dan Rasmussen on the podcast where he talked about it. I’m a little biased because we have a fund file that would do a similar sort of concept. And the reality is that it’s essentially small-cap value, and then choosing to explicitly or implicitly add leverage to that. And you can do it by leveraging the whole portfolio or buying companies that have higher debt, you end up sort of in the same place, I think, but also that flows change factors. People ask us this a lot where money in any one asset class will change it. So all the money that’s gone into private equity, you can see this over the past 20 years, private equity across the board used to have valuation discounts to the public market, and that’s no longer the case.
So this potential outperformance… I went to a conference recently, and the moderator asked the panelists, he said, it’s a bunch of big institutions, he said, “Would you expect your 5% alpha private equity to continue the next decade?” And they all kind of laughed, but then said, “Yes.” So they’re still planning on it. But, you know, the venture capital is a little different animal. The belief in everyone that allocates to those asset classes is they have the ability to pick the top 20% of managers. And that is the crux of the whole thing. Way back in the IV portfolio, we wrote about it where we said, “If you just end up with a median venture capital private equity manager, it does nothing. You should just own the S&P.” But if you do end up… there’s a much wider spread across the best versus worst performers, and they’re used to at least be persistence in the best performers, the challenge was getting into those funds.
But a lot of the academic literature has also been showing over the past 10 years that’s started to change. So this is a long-winded answer to your question that there are some benefits, by the way, huge benefits of being a private investor in early-stage angel companies, and we’ve mentioned those, the QSBS rules, etc., that give you huge tax benefits over public investments if you hold them for five years, etc., etc. Cliff Asness talked about this in a recent piece, what used to be considered a big drawback of private investing is actually probably a feature, not a bug, which is the illiquidity. And it goes back to this old wink and a nod that institutions and allocators have of, “You have to lock me in for 10 years, which is good, because otherwise, I would do dumb stuff with this money.”
And so the ability, at least to get the asset class, the problem, of course, comes with the fees, then most of these are 2 and 20 sort of vehicles, which ends up being a bigger drag. But if you could get that sort of illiquidity and leave your investments time to run, which goes back to this old idea we had about just building some funds that had 10-year lockups in the public markets, but it’s something that, you know, we all would agree would be the best for investors, but none of the investors would actually really want it when it came time to write a cheque. I don’t know I could be wrong on that one.
Justin: Well, I want to shift gears back to public markets. And one last topic here as we wind down is, you have and we’ve talked a little bit about it around here, but you tweeted a little bit about Africa. I think back several years, I had heard some excitement, some buzz around investing in Africa and at the time there were a few countries deemed as frontier markets. Now, whether we all agree on the definition of these markets is one thing, but I think, you know, looking at Africa in particular, it seems like there could be some potential opportunity there. You want to walk us through what your thoughts are?
Meb: I think most of the really basic, big, thematic ideas tend to be simple, you know, where you can kind of give the idea in a couple of sentences and that’s it. Like, you could, sure, give a 100 page PowerPoint after that to support it, but the basics are there. And Africa to me is one of those examples where almost no one I know invests in Africa. I think there is literally one ETF that has like $100 million that is essentially a South African fund because that’s the most liquid largest market. So essentially no one is interested in Africa as a market. I think that it’s not a sexy, at least not right now, place to invest. But if you were to look at it as the simplicity that I’m talking about, there’s a few things that I think nails my point home.
So, first, 14% of global population is in Africa, 5% of GDP, but only 1% of market cap. So if you look at a lot of these numbers, and the U.S. is on the other side of this, where it’s only like 20% or 25% of GDP but 55% market cap, and you’re to bet on long term trends and just demographics, like, that’s a pretty simple one to bet on. Everyone and their mother was excited and writing about India and China a decade ago. And then they got into the PE ratios again in the ’40s and ’60s. Now they tend to be a little more sober. I think India is the more expensive of the two and China seems to keep getting cheaper by the day. But Africa just falls into the category of something no one talks about. And so I think there’s probably some thoughtful ideas on building portfolios there for the next decade.
Like everything we talk about, it’s important how you go about it. So if you, again, were just to buy the top 50 market cap companies, you’re basically just gonna end up in South Africa. You’re market cap weight is probably going to all be in Naspers and in the, really, biggest of the big market cap, but I think for a 10-year perspective, having an equal weight, obviously, you know me, so having a value tilt, but knowing how your fund allocates, and this is kind of leading something else I want to talk about, you know, indexing meant something 50 years ago when it meant market cap weighting. But so many people today allocate to “index funds” that have absolutely nothing to do with market cap weighting. And the example is our buddy Eric Balchunas at Bloomberg said, he’s been on this all year, he’s talking about one of the largest dividend ETFs. And I think this is SDY. And it’s based on an index that the dividend aristocrats, like, someone in marketing definitely came up with that.
So many people on this podcast will probably love this methodology. It invests in companies that have been raising their dividends for 20 years. And I’ll probably get the specifics wrong so excuse me, this is what I recall. And that’s it, and then they weigh the companies buy dividend yield. And so if you know me, we’ve been talking about buybacks, you know, that’s already totally nonsensical, because you’re just picking out one way a company uses cash, you’re ignoring buybacks, you’re ignoring issuance, which seems really odd to do, but whatever. And also, a company like Apple isn’t going to even be eligible for another 15 years or something. So you have the world’s largest market cap company that’s not even eligible for the index because they just started paying dividends recently. So it’s sort of an old, outdated methodology that hasn’t changed with the world, but it’s a good sound. And by the way, it’s $20 billion in AUM, so what do I know?
But the problem with indexing, when you disclose your rules and follow very strict adherence to them, is you have sometime, intentional or not, consequences. And so this fund, because of its methodology, ended up owning of a couple of stocks, like 20% of the shares outstanding because there was a stock that went down. And so while it’s still eligible, if the price goes down, guess what? The dividend yield goes up. And so as the dividend yield goes up, it actually had to buy more and more of the stock. And so it got to the point where this $20 billion fund because it’s so big owned 22% of the stock, and then oh, by the way, it’s rebalancing and it has to sell it. And so all of a sudden, you’re going to be just liquidating out of this… It’s just such a nonsensical way to go about and we talk about this, I’m agnostic, I’m a quant, we’ve run index and active funds. In my mind, everything is active and index no longer means anything as we just mentioned in 2020.
And so there’s enormous amount of literature that shows that indexes get picked off all the time. And it’s called the dirty secret of indexing where some of the big indexes like S&P, it may be only a cost of 10, 20 basis points a year or something. Everyone used to time the Russell rebalance, so you know it’s coming in, you know it’s coming out, you would short what’s coming out, buy what’s coming in, and it would be a consistent profit over the years. But there’s indexes like these, where it’s even more extreme and it’s a very real cost. And so there’s some indexes, and I’ve seen academic literature that shows that it’s an annual cost of 1% to 3%. I think in one commodity index it was like 4% per year. And so why in the world would you ever design or allocate to a strategy that does that? It’s totally baffling to me.
And we’ve often said the best approach if you’re doing an index is do an actively managed index. Meaning you have an index, but you run it in-house or you run it in ways that it’s not completely adhering to the rules that you’ve published publicly. Or you do it in a way that’s at least thoughtful about the trading. And I’m sure State Street, or whomever the manager of this probably actually managed the trading thoughtfully rather than just puking out 20%. I don’t know. I don’t follow it because I would never allocate to a fund that had such a nonsensical investment theme. But it just goes back to like, imagine having a conversation with your advisor and by the way, there’s gonna be thousands of people that are listening to this, that allocate to this fund and many others, because it’s a good narrative.
You get to invest in dividends, it’s companies that have been raising them for 20 years. Like, that’s an easy story to tell your client, you know, that fund goes down 50%, 80% like it could at some point, and your clients say, “No, no, we’re investing in these businesses, they’re dividend payers, they’re the safe ones, the blue chips,” right? You know, people told the same story in the nifty ’50s. These blue-chip stocks. But when you dig underneath, and when you should do this with all your funds and investing approaches, you realise that the reality is actually quite a bit different than probably what most people think it is. And if you were to tell someone “Hey, do you know this has been buying up 20% of the actual stock?” People would say, “That’s seems a little odd to me.” So, anyway, know what you own goes under that theme, and I think it’s important.
And if you’re in, deck it in, a good time to reflect to, you know, we had two very brief mailbag… You guys have got to send us some more mailbag questions. Justin’s getting light on these. I asked on Twitter, shoot email@example.com. But we had a couple and you guys are, if you send me an email, DM me or shoot that to that email, we’ll try to read some. Here’s two real quick because I think they’re similar questions that we get a lot. One asked me, “Hey, Meb, how do you find inefficiencies in the option market?” I’m going to take a step back and scratch the word option and just say market in general. And to me, the answer to that is you either have to have better or different data. So is your data better than someone else? I mean, go back 100 years when someone used to have, you know, a telegraph that would get there faster than someone else’s information. Or do you have, as the hedge funds probably did in the last cycle, quasi-insider information, are your satellites giving you information that no one else has? So better or different data that no one else has, or if they have a better model.
This doesn’t apply as much anymore. Is your option prediction model better than the rest on the street? Do you have a valuation model, or a discounted cash flow model that predicts stock returns better than other people? So as far as inefficiencies, it’s a lot harder these days, and going back to the old, sort of, Munger quote, “Go where the fish are and the fishermen are not.” This is probably a lot easier if you apply some of these lenses to, say, companies in Africa, like we just mentioned, are places where there’s not 200 analysts following them like Apple, but rather securities, asset classes that are not that efficient and large cap U.S. stocks is probably not the best place to look.
One more question. “Hey, Meb, read a lot of your work for years. Fantastic content.” Thank you. “At this moment in time, what is your best guess at the highest Sharpe strategy? This could include any combination of asset class sector geography and market timing. I’m not asking for a silver bullet (almost am) but if you had unlimited free leverage where, how do you target the best Sharpe?” So that’s an easy answer. You can get the highest Sharpe by doing option selling. You could do sell options, straddle, strangles on one market if you really want to get crazy. If you want to be at least a little more thoughtful and do it on 10 or 20 markets, that’ll get you a Sharpe ratio of 2.0, maybe 3.0. You’ll make consistent 1%, 2% every month. The bad news is you eventually blow up. You don’t have to. If you position size small enough, you could be okay but most people don’t because they want to get 2% a month, 3% a month.
If you can go Google option selling, probably Meb Faber and get some old blog archives that show that I wrote about them in real-time, we had profiled a bunch of option writers and I said these are eventually going to blow up and I don’t think any of them still exist because they all got taken to the cleaners. So that’s certainly a strategy. Now we actually did the modelling on this back when I still lived in Tahoe is that if you actually did the option writing and biased it away from the direction of the trend, so if the trend in say, oil is down, you would actually be selling options, the straddle or strangle but biased in the direction of the trend.
So if the trend is down, you’d probably be selling more calls than say puts, that ended up with quite a bit better performance on top of that. The key to me, if you’re being serious about this approach, would be you have to have maximum diversification and small enough position sizing so you don’t lose all your money. But this is a classic example of picking up quarters in front of a steamroller. It has a very nasty left tail. But the good news is you’ll be able to raise a few hundred million from institutions because you have the highest Sharpe ratio for a few years. And if you’re lucky, it may last 5 or 10. But eventually, you’ll face the music. You got anything else for us before we wind it down?
Justin: No, let’s wind it down.
Meb: All right, listeners, shoot us an email at firstname.lastname@example.org. We love listening to feedback, give us review. Put it on iTunes. Even the nasty one we got recently. They actually sent me a T-shirt and a coffee mug, so thank you. They printed it out on a T-shirt. Subscribe to the show on iTunes, Breaker, which is my current favourite. Thanks for listening, friends, and good investing.