Episode #294: Dan Rasmussen, Verdad Advisers, “A Lot Of These Regime Changes Happen Around Recessions And Crises”
Guest: Dan Rasmussen is the Founder and Portfolio Manager for Verdad Advisers, a global investment firm that provides a public market alternative to private equity. Before starting Verdad, Dan worked at Bain Capital and Bridgewater Associates. Dan earned an AB from Harvard College summa cum laude and Phi Beta Kappa and an MBA from the Stanford Graduate School of Business. He is the New York Times bestselling author of American Uprising: The Untold Story of America’s Largest Slave Revolt.
Date Recorded: 3/1/2021
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Summary: In episode 294, we welcome our guest, Dan Rasmussen, founder of Verdad Advisers, a global investment firm that provides a public market alternative to private equity.
In today’s episode, we start with an update on Dan’s private equity replication thesis and hear about the rise of private credit in the past few years. Then we dive into his recent paper on emerging markets crisis investing. While buy and hold investors in emerging markets have experienced higher volatility for disappointing returns, Dan believes learning to navigate these EM crises can provide the ability to reap excess returns. He walks us through the differences between global and idiosyncratic crises and what performs best between both debt and equity in each case.
All this and more in episode 294 with Verdad Advisers’ Dan Rasmussen.
Links from the Episode:
- 0:39 – Intro
- 1:31 – Welcome to our guest, Dan Rasmussen
- 2:08 – The Meb Faber Show: Episode #90: Dan Rasmussen, Verdad, “The Crown Jewel Of The Alternative Universe Is Private Equity”
- 2:20 – How things have changed for Dan since his first appearance
- 5:43 – Measuring high yield spreads
- 9:32 – Crisis Investing: How to Maximize Return During Market Panics (Rasmussen)
- 14:45 – Subscribe to Verdad’s Email List
- 14:57 – How has the institutional community received Dan’s research and investing philosophy
- 21:28 – Secular opportunities in the markets
- 23:43 – His early call on Japan
- 27:47 – Understanding the lessons of history and then knowing when to forget them
- 30:46 – Emerging Markets Crisis Investing (Rasmussen)
- 36:15 – Investing in emerging markets
- 46:00 – Creating a coherent strategy for investing in emerging markets
- 50:34 – Should investors look at investments in individual countries and how will currency moves play into this
- 54:33 – The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets (Faber)
- 55:43 – His thoughts on FOREX
- 1:00:24 – Dan’s thesis about private equity
- 1:04:50 – Commodity investments
- 1:07:31 – New ideas he’s focused on
- 1:11:14 – Connect with Dan: twitter @verdadcap, verdadcap.com
Transcript of Episode 294:
Meb: 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.
Welcome Message: Hey, what’s up, y’all, great episode. Our returning guest is the founder of Verdad Advisers, a global investment firm that provides a public market alternative to private equity. In today’s episode, we start with an update on our guest’s private equity replication thesis and hear about the rise of private credit in the past few years. Then we dive into our guest’s recent paper on emerging market crisis investing. While buy and hold investors in emerging markets have recently experienced higher volatility for disappointing returns, our guest believes learning to navigate these crises can provide the ability to reap excess returns. He walks us through the differences between global and idiosyncratic crises and what performs best between both debt and equity in each case. Please enjoy this episode with Verdad Advisers’ Dan Rasmussen.
Meb: Dan, welcome to the show.
Dan: Thanks, Meb, it’s good to be back.
Meb: It’s been two years, my God, nothing’s happened in the meantime.
Dan: A global pandemic, you know, other than that, not much.
Meb: You replicated at least once maybe twice with children, you’re in a new house, moved cross-country. My God, man, it’s great to have you.
Dan: I know, it’s been a crazy two years. Well, it’s great to be back and great to get a chance to catch up with you, Meb.
Meb: Why don’t you tell us a little bit about what’s been going on. We’re going to talk about all things crisis in a minute, emerging markets, two of my favorite topics, but also people, I’m sure, that loved your first show. We’ll add a link to the show notes, episode 90, you’re in the first 100.
Dan: Oh my gosh, that’s awesome. We should tokenize it and issue some sort of coin.
Meb: That’s 2021 for you. All right, so last time we had you on, talking stocks, talking private equity, all that world you’re trying to disrupt it, your firm was sort of in its infancy. Walk us forward, what’s been going on?
Dan: We’ve grown a huge amount since 2018. So we’re nearly $600 million in assets under management. And I forget where we were in 2018, maybe we were at $50 million then, so it’s been a, sort of, rocket ship ride out, which has been great.
Meb: Way to go, “Med Faber Show” podcast listeners, I attribute at least $500 million of that to our…
Dan: I attribute it to the podcast as well. So it’s been a lot of growth, which has been great, firm has grown. And on the other side of things, we’ve dealt with a pretty rough period in the equity markets, right. So as you remember, so my thesis on private equity replication was that the core driver of private equity was buying, you know, micro-cap deep value, and from 2018 through Q1 of 2020 was if not the worst time ever to do micro-cap deep value. I mean, it just couldn’t go right. And the smaller the company you bought, the cheaper the company you bought, the worst you did, it was enormously stressful for me.
And I think that what we focused on trying to answer in that period, is our analysis wrong? Is our empirical work wrong? And we came up with a glitch that wasn’t right, that there was just something unique going on in small-cap value, relative especially to large-cap growth just done really, really well. And start to think about okay, well, how do we think about when small value works, right? So uncovering this idea, right, you sort of think, okay, small value, you discover it for the first time you say well, this is genius, it’s the best strategy, or it’s the highest returning strategy. And gee, micro-cap and deep value, right, the more you load up on those factor exposures, the better you’re going to do, right? Any backtest you do over a long period of time tells you the exact same thing.
And yet from 2018 to Q1 of 2020, right, you’re just getting told by the market every day that that’s wrong. What I started doing work on or, sort of, asking myself…and especially coming from private equity, right, where you can make up your own marks for two years. So you don’t have to discover you’re getting whacked, right, so you can just ignore it completely. But in the public markets, right, you see that day-to-day fall, and you’re dealing with that company that’s number one ranked in your quant model that just went down 30% or something, right. So you know, you have to reckon with it and say, well, when does small value work? Or during the 2018 to 2020 period, when will it work again because it’s not working right now?
And that led us to, sort of, try and relate how the macroeconomic environment relates to the performance of small value. And we’re going to get into some heretical ideas around market timing, right. So we’re getting out in some dangerous ground and I know some people object to, but the question is are there times when small-cap value is more likely to work than others? Are there economic periods when it’s less likely to work than others? And how can we, kind of, explain what’s going on?
And the research we started doing, and what’s really driven our firm’s growth, probably the majority of which has come since March of 2020, we basically found that small-cap value dramatically outperforms coming out of a recession. So if you buy small-cap value in a recession, your odds of the small-cap premium, or the value premium, or both can go up dramatically, right? There’s academic research that says actually, those factors are 8X more predictable in times of crisis. And the simplest way to define a crisis in small-cap value world is through the high yield spread. So high yield markets…so high yield issuers are small, they’re issuers of debt, they’ve got some issues. And so the high yield spread goes above sort of 600, we sort of define that as a crisis or a recession.
Meb: When you say high yield spread, what are the two metrics you’re, kind of, measuring?
Dan: The high yield spread is the difference between the rate that high yield borrowers issue data and the underlying treasury rate, then it’s adjusted for duration. So think of a normal spread as sort of 350 bips or something like that. One standard deviation above normal would be 600. And if you think of where we hit in, like, you know, March, it was well, well above that.
But we basically said look, you know, if you think about why that happens…what high yield spread is measuring is a few things. It’s measuring lending. And as it’s measuring lending, that’s also a proxy for equity investing, right. If no one’s lending to these companies, then no one’s buying their equities either, right, so getting starved of liquidity. And if you think that the small-cap value premium has anything to do with liquidity, this is telling you that the liquidity premium has just gone up massively. And the risk of default, which also could potentially be driving this, has gone up massively.
And then the other thing is that the high yield spreads are really good contemporaneous macro indicators. So it’s telling you, with a pretty high degree of confidence, the economy is in a recession. If a high yield spread is over 600, you’re pretty sure you’re either in a recession, or in a quasi-recession, or industrial recession, or some type of recession. As we sort of peel back the onion, right, you sort of say, okay, high yield spread is indicating liquidity, indicating a lack of market optimism, or severe amount of pessimism about these types of companies. And when you think about so that’s driving your, sort of, liquidity or size factor, and what’s going to drive your, sort of, value factor in those periods is the recession.
So if you think about now, value stocks, right what are most value stocks? They’re industrials, they’re consumer discretionary, they’re a lot of financials, right? Well, what happens in a recession? Well, consumer discretionary spending plummets. Nobody…all the factories stop producing things, and interest rates drop because the Fed takes rates to zero. So who gets whacked? Well, cyclical consumer discretionary companies, industrial companies, and X, which means the small-cap value world.
Well, what happens after a recession? Well, if GDP was down 5, and that meant that the industrial manufacturing sector was down 20 in terms of revenue, or profit or whatever, right, well, to get back to even, you’re going to have massive rebound in earnings, right. And interest rates are going to go up and the banks are going to benefit, and the cyclicals are going to benefit. And so you’re going to have this…and the value stocks, right, at those moments, you’re buying into value at a time when earnings are in a trough. And so if you’re buying into those companies with trough earnings and at low valuations you’re actually paying less but getting way above-average growth. So usually value stocks see declining growth or flat growth relative to growth stocks to actually grow. But in a recession, it’s reversed. It’s the one time you see like some crappy auto parts manufacturer grow faster than amazon.com is like Q1 of 2020 through Q1 of 2021, right, when you see that, sort of, growth value dynamic reverse.
So what we started talking about really, actually probably as early as 2018, I bet, if we went back into a transcript search of our conversation the high yield spread came out. But we started talking and saying, look, small-cap value and private equity replication is a great buy and hold strategy for the long term. But if you’re trying to time it and if, sort of, short-term results are important to you, what you want to do is buy-in after a crisis when high yield spreads are blown out, and basically ride it out until the economy normalizes.
So what we’ve really been focused on, I’d say since 2018, is grappling with volatility, grappling with market timing, or at least trying to think about when factors work and don’t work, dealing with, sort of, the quantum apocalypse of Q1 ’18 to Q1 ’20. And really doing a huge amount of work on this idea of crises, how to invest in crises, how crises work, and why crises are, sort of, uniquely special times for especially vector-based investors. But I think for all investors because I think it’s a really, really important thing and it drives so much investor behavior, and I think it’s been an understudy.
Meb: This paper came out…when did you guys first publish this one? And we’ll add that link in the show notes, listeners, on crisis investing.
Dan: When I published that actually it was done in January of 2020. I think we published it early February of 2020.
Meb: I thought so, amazing. Well, I mean, it’s, kind of, played out that way, right? I mean, you had small-cap value, looking at some of the metrics, got absolutely nuked in Q1. And then have had this just amazing run since and it depends on where you want to put the, sort of, peg of when that world has shifted. And it seems like a big regime shift to me. Not a lot of people I don’t feel like still appreciate the, kind of, tide shifting. Walk me through it, did it play out like you guys wrote about in the paper, was it a little bit different? The spread sure did blow out.
Dan: Basically, we had this whole thesis, right, which is that in a high yield crisis if you buy into small-cap value, the smaller the companies you buy, and the cheaper the companies you buy, the bigger will be the rally when the economy recovers. Now, you don’t know when the economy is going to recover, right. So you don’t know how fast the rebound is going to happen. But with a really high degree of confidence, much higher than normal, you can guess that there’s going to be a size premium and you can guess there’s going to be a value premium.
And what you saw in this recovery initially, I’d say let’s say March through October, what you saw was a size-based recovery. So small-cap started ripping, but it was growth that was leading, which is really weird, right? I mean, that’s not a normal thing. It’s not size rips but it’s weird to see growth leading, but growth was really leading through October. I think there are some elements of a bubble in some of the small-cap growth world, I think there are some elements of euphoria, I think it’s pretty scary. But that’s abnormal. Size was working, right, so anyone that bought small value, you were benefiting from the size effect even if it weren’t getting any juice from value.
And then November the vaccine was announced and value just has taken off. And it has been…I think that’s exactly what we had predicted and I think it’s all around. Again, what we wrote about in that paper was first you have the liquidity flow back in the markets, right. And that is really, obviously what’s going to drive a size premium. And the smaller the company, the better, and that’s played out too right micro-caps have done better than small, small has done better than mid, mid has done better than large, right. Just, sort of, a perfect factor just as you’d expect to see based on our research.
And then where we start to see value playing out is when you start to think about, okay, what are 2021 earnings going to be like? And then you start to do the math, again, you’re looking at these auto parts company, or these paper packaging company, or a company that prints signs or write these boring old-world things that just nobody cared about. Or especially 2018 through ’20 when everyone was talking about disruption, and blah, blah, blah. And all of a sudden, you’re looking at earnings forecast you’re like, wait, do I own Amazon or Facebook or something, right?
This thing is forecasting a 30% year-over-year revenue jump. And you just realize it’s like, oh, yeah, the reason everyone was avoiding small-cap value, or why multiples were compressed is because they’re worried about cyclicality and GDP exposure, right. And so you just got paid off in a big way for avoiding small-cap value in March of 2021, right…March 2020. If you say, “Small value sucks, I’m staying out of it, I’m going to stick to large-cap growth,” you got paid because you bet that cyclical stuff was going to get whacked at some point. And it did, so you were right.
But the reversal of that is what so many people missed, right, because the good thing about cyclicals is when the cycle turns, their earnings turn, and the GDP link goes from being a bad thing to a really good thing. And that’s the regime change we’re seeing now. And I think the other thing that’s worth noting is that I think we spent years and years studying this to kind of come to this conclusion now, delighted that it’s proven right, and delighted that it’s happened that way and it’s worked out that way.
The other thing that is, sort of, worth reflecting on here and thinking through is that there’s so much more room to run. Because what a lot of investors do is they’re not, sort of, forward-looking. They’re not saying, “Oh, great, you know, Q1 of 2020 looks exactly like these beat prior crises of the past 50 years.” They’re saying, “Hey, what works over the past year or over the past three months, and I should get me some of that,” right? Like, wait, you’re sitting on your investment committee, you ask your consultants, like, “Hey, why are we underweight small-cap value and that’s been the best performing thing?” And they say, “Oh, well, we can fix that, let’s hire a new small-cap value manager, right. And let’s move some of the money from what’s underperforming with large-cap growth into small-cap value.” All of a sudden, you’re trailing liquidity flow start to Russia.
And so I think these regime changes tend to have some sort of feedback loop component to them. So I’d say that regime change, which I think started in November and took a lot of people by surprise…If you read our paper, and not to boast but you wouldn’t have been taken by surprise because I think this is what happens after every crisis. But that is a long ways to run. Our research would say you’ve got probably two years, two years when those factor exposures just, sort of, run before you’re, sort of, back to normal. Unless you have some sort of double-dip or another crisis, right we get hit by some other pandemic, right, a year from now and you know, forget my two years thing. But I’d say from a, sort of, base rate perspective, these things build on themselves, they have a feedback loop element to it. And once the party gets going, it tends to last for a little while. And small-cap value has been so beaten up for so long that, gee, just to get back to normal with the S&P 500 or break even with the S&P 500, we’ve got a lot of outperformance ahead for small-cap value.
Meb: Well, good. I agree with you. And listeners, the Verdad team, sign up for their email list, the link they put out. They dribble out once a week, I think, research pieces over time. So I’ve been reading these over the past few years, all sorts of different topics, including bonds, and we’ll get some more ideas in a minute.
Dan, what is the reception been for you guys in the institutional community? Because if I was CalPERS, or an endowment and read a lot of your early research on private equity replication within the public markets and what y’all are doing, not to give you a softball, but it’s kind of hard to argue with, in many ways. To me, it seems like such a thoughtful approach. What is the discussion been like as you’ve had conversations in the last few years, as you continue to talk to allocators about some of the ideas there? Are they receptive? What are, sort of, the struggles they have with thinking about this approach? Is it career risk involved? Is at the structure of having a 10-year lockup in private equity? Just give me a little color on your discussions the past few years.
Dan: And coming on this podcast has been a part of it and writing about this has been a part of it. But I think there’s been a shift, a definite shift in the way people think about private equity. I think, well, there’s still a lot of boosterism about private equity. I think every booster is also aware of the counterarguments now, which I don’t think they were three years ago. I don’t think they understood the liquidity risk. I mean, I think maybe they understood the liquidity risk, but the leverage levels, the valuation risk, really what was, kind of, going on a deal by deal basis, I don’t think people were well informed.
Meb: Where do those stand today? Are they similar to where they were when we first talked? Are they getting worse?
Dan: That’s sort of funny, right? I mean, I think that one of the things that’s happened, and I wrote about it last year, but you had to shift right after the financial crisis where regulators came in and said, okay, we got to clean up bank balance sheets. And there’s some really interesting writing about this, right. But banks have always been, sort of, like they’ve turned into utilities, right, so much of the risk has been taken out of bank balance sheets, right. All the crazy things they were doing, right, in ’07, they’re just not allowed to do. And there’s a good reason for that, right, it blew up and it was bad.
But one of the things they stopped doing, or virtually stopped doing, private equity lending. The regulators took a look at that and said, “Hey, gee, this isn’t worth it.” And the banks took a look at it and they said, “Gee, we haven’t really made that much money here. The default has been really bad, right? This seems like…let’s focus on something else.” And there emerged this new industry called private credit, which is actually a pretty hot thing.
And private credit basically, you know, it started with like KKR, or Blackstone, or all these firms just opening a credit arm that would lend to other private equity firms when they did deals. They’d say, you know, “These deals are so good, why should we give away the lending to the banks? You know, why don’t we create our own lenders and we’ll end up giving.” And those private lenders, which had money from endowments, and foundations, and insurance companies, had none of the regulatory scrutiny that the banks did, and so have been able to innovate, right.
And there’s only so much one worries about financial innovation, there are just two words that you get a little bit worried about. You’re sort of like, this is the reason why old insurance companies used to be built with like…and banks built with like Greek columns and built out of marble, right. They were, sort of, saying we don’t get offended, right, we’re going back to the Greeks, we’re trustworthy, we’re safe, it’s a Roman building, you know, you can trust us. But financial innovation has obviously evoked these in a number of places.
But these private credit firms had much lower standards than the banks, and because they’re run as funds, their desire is to deploy capital, get deals done, relative to banks, which might have had other lines of business. And so the arrival of private credit has pushed leverage ratios, EBITA adjustments just to, kind of, crazy, crazy levels. Now, a good part of that for the sponsor is that in their marketing deck, the private credit firms say, “We haven’t had any defaults.” They don’t have any defaults. So anytime the private equity firm would have defaulted, they trigger a covenant, things are looking bad, the private credit firms just renegotiate.
They say hey, you know, we’re not going to put you into default but we’re going to extend number 10, or change the terms, we’re going to give you a loan interest forgiveness. And when you look at adding those, sort of, adjustments back in, private credit sort of looks like triple C type debt, or even worse, but that has fueled the private equity boom. So you’ve just seen a continued explosion of liquidity flowing into private equity. You’ve seen a continuing expansion of leverage levels and a continued expansion of purchase prices as a result.
I just think it’s so risky and so dangerous, and it’s just not worth it. But you know, I’d say those ideas are out there, right, and you’ll hear people talk about them. And I think most institutional investors will say, “Hey, we get it, we understand the risks we’re taking, we know about leverage levels, we know about these purchase prices. It’s a risk, we factored it in, what we don’t see is any behavioral change yet.” So investors are still equally as excited about private equity as they were three years, if not more excited. I don’t know when that ends.
One of my mentors said, “It’s easier to know what will happen than when it will happen.” I’m pretty sure I know what’s going to happen because we’ve got all the seeds, right. You’ve got illiquidity, you’ve got crazy leverage levels, you’ve got excessive optimism, you’ve got a very small exit door if you want to get out of those things. All the ingredients for a tragedy are there but when it will happen, I don’t know, and I think I’m calling it too early.
Meb: I think it’s shockingly, kind of, simple the way this probably plays out is that you and I both know the people allocating to these sort of strategies of the last 3, 4-year vintages, you have a 10-year horizon on many of these funds. And the people that allocated, they’re gone, they will very likely have moved on to a new position, retired, whatever. And so when the results start coming online 2024, 2025, they’ll be like, “Well, that was really stupid. Where’s Jim?” Or you know, “It wasn’t me, I wasn’t here, the one that allocated.”
And so you’ll see the behavior probably in like three years from now where everyone will be like, “Oh, let’s reallocate to something that makes more sense that’s not as expensive.” But that’s sort of the way the world works, in the institutional world, so we’ll see, I don’t know. CalPERS still hasn’t responded to my offer. I applied online to their CIO opening and I said, “I’m happy to do this for no salary and I’ll put you guys in a bunch of publicly listed ETFs and strategies.”
Dan: You should just start running an annual tracker of how much better CalPERS would have done if they accepted that offer than whatever in God’s name they’ve decided to do. I feel like it’s just a comedy of errors over there.
Meb: I say we’ll have one yearly meeting and we’ll have a few beers and that’s about it. Not even interview yet. So I’m going to be upset if they don’t reach back out. Zero-cost, CalPERS, if you’re listening.
Dan: Well, I can come in with you every year to consult with you on the private equity portion. We’ll have a beer and we’ll say, “Meb, should it be zero again this year?” And I’ll say “Yes, Meb, it should be.” And we’ll have another beer. It’ll be great.
Meb: The valuations alone…I mean, this was I think a pretty eye-opening insight dating back to your days at Bain even where the value spread of what used to be what you were getting is not the same. It’s like markets are always…like, it’s like a swarm of bees, right, they change over time. And sometimes private equity made a lot of sense because it was a lot cheaper. But that’s not really the case in 2021.
Dan: You think of these sort of big, secular opportunities but I think there’s something that, sort of, defines the model, right, which is that something is really unpopular and cheap. People are uncomfortable doing it and so you’re able to buy assets at a really low price, right. That’s sort of what a lot of these, sort of, great trades of all time…and sometimes those great trades have been like, hey, right after the financial crisis, nobody wanted Microsoft, for whatever reason, Microsoft traded dirt cheap, right. And Microsoft turned out great, but private equity had that element to it, right?
There was a time when these were alternative assets precisely because they were out of the mainstream at 80% or 90% allocators, saying we don’t do that, we just do public stocks and bonds. We’re not doing that, that’s an alternative, that’s weird. And when Cambridge Associates and the Ford Foundation, Harvard Management, Yale in the early ’80s said, “Hey, maybe there’s some money to be made in real estate, or unlisted companies, or venture,” right. They were doing something that was very uncomfortable and very, kind of, out there. And as a result, they were able to scoop these things up at just these crazy low prices.
And it turns out, if you can flip them to a public company, or list them or make them less weird and less unattractive, you earn a big premium for doing that. But I think the history of markets is not replete with a lot of examples of great trades, sort of following what everyone else thought was the best idea and best practices, right. When everybody is telling, “Hey, best practice is to put a very large percentage of your portfolio on this asset because it offers the best returns,” right. That is not typically been the thing that’s led to great outcomes, it just hasn’t.
Meb: Somebody had a tweet the other day that was pretty good that we all know what the returns of certain strategy has been over the past few years. And all of a sudden, every big asset manager, there’s something like 40 funds filed with innovation or disruption in the name. And it’s like, how can you be one of these shops and take yourself seriously chasing, as you know, just the hot dogs? The average public mutual fund, half disappear every decade. I mean, that’s astonishing to me, they just go away.
You guys were also talking about a market that was pretty out of favor that’s now broken out for the first time in, I don’t know, three decades, Japan. That was when you guys were early on, it’s kind of played out. Tell me a little bit about what’s been going on over there.
Dan: We’ve been really excited about Japan for a while. I think there are some structural things we love about Japan, it’s a really big market. They’re at 3,000 listed equities. So almost the same number as the U.S., which is kind of insane. It’s the second-largest equity market in the world, really, really cheap, okay. So if you want to go high, the cheapest decile of Japanese companies, you’re buying stuff at like three, four, or five times EBITA, it’s just astonishingly cheap. And the cheapest decile, remember, is like 300 stocks. So you’ve got a very plentiful opportunity to buy just crazily cheap stuff.
And I think the usual risk in Europe or the U.S. that you face with buying crazily cheap stuff is that it’s going to go bankrupt. So yeah, you can buy the Yellow Pages for three times EBITA but a year later, the Yellow Pages are out of business. But Japan, there’s this, kind of, culture where they don’t like bankruptcy. So basically, like, if you’re publicly listed, you’re going to be publicly listed forever, and the government, the banks, and everyone is going to try to make sure a way to find you never fail because they have lifetime employment guarantees that’s just not acceptable.
So it’s a really cool market to do small value, it’s big, lots of selection opportunity, really cheap, and without the, sort of, downside risk of the bankruptcy that causes so much pain for small-cap investors growth or value in the U.S. and Europe and elsewhere. And you don’t have to face…right, you look at the other countries that are as cheap as Japan and you’re like Japan, Russia. And you, sort of, sit back and say like, how do I compare Japan and Russia on, like, the things I might be worried about, like corruption or like regulatory disclosure so the rest of my equity is going to be expropriated? Or just like pretty much any possible risk I can possibly conceive of, I’m like, Japan feels pretty safe and so why is it trading these valuations? By the way, the U.K. is now getting into those levels, too so we can talk about that more too. But when the U.K. is now getting into those levels too, it’s kind of crazy, but Japan has been there for a while. And I think you’re starting to see Japan break out. You saw Buffett invest, right? You saw Japan…finally the Nikkei is above 30-year highs formed in like 1989. And I think a lot of people are starting to say, “Hey, gee, maybe I should have some bigger exposure to the, you know, second-largest developed market in the world, maybe that would be a good idea, and maybe it’s pretty cheap.” And valuations today, by the way, if you compare Japan to the U.S., it’s an exact inverse of 1989.
In 1989, the future was Japan, Japanese companies were the best around, all innovation in the world is happening in Japan. Now it’s the U.S., all innovation happens. The U.S. management style is better. If people outside of the U.S. can’t run companies very well, they’re not innovative, right. Japan, you know, time-bound, they run things the way they’ve always run, it’s boring, right, exact inverse. And I think if you think about benchmarking what the next 30 years look like, I’d be a lot more optimistic about Japanese equities than U.S. ones.
Meb: That’s the thing, I mean, it’s so obvious when you talk about historical cycles. I mean, every country asset class has its time in the sun. And Japan is like, literally, the biggest example in every possible scenario, you know, the biggest bubble in the ’80s and then literally three decades. I was sad to miss this past year, we do an almost annual ski trip to Japan and get to hang out with some local investors and traders. We do a meet-up in Tokyo. And you talk to a lot of people, the culture of this buy and hold mentality for many doesn’t really exist because for their entire life, the market has essentially, on an absolute basis, gone nowhere. It’s just been up and down, up and down, sideways, recovering from this bubble.
And so again, as you mentioned, this isn’t some tiny country or economy, this is top five on every metric, right? And so you’ve had an entire generation, not just within Japan but globally, where their hands have been burned so many times trying to buy something. And then by the time everyone’s given up, voila, here we are, and it’s just this amazing opportunity. But that’s kind of you know, like, looking into the things that have been just beaten down over time is usually a pretty fertile place to search.
Dan: It’s trying to anticipate, right. I think that our goal, both yours and mine, and I think we sort of think the same way, you know, trying to anticipate these things before they happen. When there’s going to be a secular change, you want to get in first, right? You want to deploy your capital, and then you want small value. You want to deploy your capital, then you want people to realize Japan is an opportunity, right? You want to get in first because those secular shifts, when they happen, they can really start to run real fast.
And so I think you think, okay, well, how do I know about that, right? If I know that it, sort of, seems like every 10 years, everything I’ve learned over the past 10 years is wrong for the next 10 years, right? So how do I, sort of, know what to do if not relying on the last 10 years performance where I’ve learned all these lessons, right? I’ve learned these lessons, and yet, I have to now completely unlearn them over the next 10 years. And that’s, sort of, the challenge to investing I think. So the only way to do that is to look at history over long periods of time and say, hey, gee, let’s look at other prior histories of regime change and how something started to work and then they stopped working and something else works.
And what are, sort of, the patterns and what can we, sort of, rely on? I think there are a few big things you can rely on, right? Like, one is that valuations, they do matter, and, of course, a richly valued country or company can get increasingly richer and more overvalued. And again, it’s that idea it’s easier to know what’s going to happen than when it’s going to happen. But you know that when you buy that really expensive company, that really expensive country, right, most likely your odds aren’t that good. And when you buy that really cheap thing, most likely your odds are pretty good.
And then I think if you want to get beyond that, sort of, the buy and hold attitude of constantly gravitating towards the cheapest thing, the best opportunity, there are, sort of, a few kind of tools I’ve, sort of, come across or read about or tried to implement. I think one of the most significant is I understand that a lot of these regime changes happen around recessions and crises when there’s a reset. I think that’s been historically true where you just, kind of, look and you can demarcate the history of equity markets and what’s worked and not worked by looking at these recessionary periods and saying, hey, did it work coming in, work coming out? And the answer is almost inevitably no.
And so I think thinking about crises as, sort of, these moments of regime change, moments when the pattern that you’re looking for as an investor, where history is going to tell you what to do in the future, it’s just more reliable. It’s a very helpful rubric. And I think one of the reasons for that is most people that aren’t informed by long term may start panicking, going through a fire sale. And if you’re keeping your head cool, and if you’re saying, “Well, gee, you know, 2009, March 2009 was a pretty good time to invest in the stock market,” you’re thinking very differently from the average investor.
Meb: Even think back to a year ago when everyone was spending every night looking at the futures again, and things on the screen were just, I mean, down double digits on some days, and how you feel. So much of this is that squishy, behavioral, emotional side and 2009, those are pretty short crises, you know, certainly within the U.S., and then compared to something that’s just as long and unrelenting like Japanese stock market, three decades of just nothing and how that weighs on your psyche, it’s tough.
Let’s pivot a little bit to where the crises are even gnarlier and deeper and seem to be happening on average every year somewhere. You got a good quote from Tolstoy in the beginning, speaking of authors from that country where, “Happy families are all alike, but every unhappy family is unhappy in its own way.” How’s that a lead-in for your new paper? When’d this one come out?
Dan: We just published it in February, so psyched to be talking about it with you. I haven’t done any talks on it, or podcasts or anything so this is the first time. We started thinking about crises and where crises happen the most, as you said, Meb, it’s emerging markets. If you think about investing in crises in the U.S., you get a few at-bats or you expand that to developed markets, get a few at-bats. You expand to emerging markets, you’re getting pretty frequently. In fact, I think crises in emerging markets have about 2X as often as they do in developed countries, right? So these are happening fairly regularly.
And the other thing that’s really interesting about emerging market crises is that they are, sort of, precipitous drops. If you look back in ’97, ’98, EM was down 50%. And the U.S. market was basically flat, right, so ’98, that was the big EM specific crisis. Then you have 2000, 2001, S&P is down 30%, EM is down 50%, then, ’08, ’09, S&P down 50%, EM down 60%, right. So when there’s a crisis in the U.S. or developed countries, you know EM is getting whacked even more. And then there are all these idiosyncratic crisis where some country just blows up for its own reason, right, and those happen a lot too.
So we got started thinking, well, if we study these crises in the U.S., right, we think we kind of understand them, what about emerging markets? Can we go and look at what’s going on in those markets and how should you navigate emerging markets? I think emerging markets weren’t an area I really studied that much or spent that much time on, in part because I came from this private equity world where EM was very peripheral to private equity investment, right. Private equity is really a developed market phenomenon. So it was really, kind of, new to me and I started digging in. It’s been fascinating. So I think there’s been a few really interesting things, right.
So the first thing I was so shocked by, right, I think if you think about…especially people who became investors in the ’90s or the 2000s, there was this very strong consensus about emerging markets, same as the small value premium, right? There’s a small value premium, there’s emerging market premium, why is emerging market premium exist? Well, there’s sort of this small…you know, emerging countries, their GDP just catches up to the developed country. And so you get higher growth in emerging markets, and then higher growth translates to higher equity returns, and you get paid to own them. That was very much the consensus. I think it was like in the CFA or something, right.
But certainly, right, anyone reading GMO or worked at Cambridge Associates, or whatever, at the mainstream of finance pretty much agreed in those periods that EM was a super return opportunity, it was just a place you harvested excess return just for doing it. That’s just has been wrong, it just hasn’t played out that way at all. I think if you look over the past 30 years, EM has returned like 5% a year with a 22% standard deviation. The S&P 500 has returned 10% or 15% standard deviation. So you’ve accepted like wildly more vol for really mediocre returns, even though emerging markets actually had GDP growth that was roughly 5% a year over that period and developed markets were growing at 2%. So the, sort of, GDP thesis was kind of right but the equity just didn’t translate to equity returns at all.
So you start thinking about why? What happened? Where’s the disconnect? It’s two things. I think one big thing is crises, right? You just had these wipeout moments where, say the Philippines in ’97, the Philippines have never recovered. It’s like Japan, right. The Philippine equity market has never recovered from its 1997 high and that’s not uncommon. If you look at 50% drawdown, which again, happen pretty frequently in EM and much more rarely in developed markets, your chances of recovering from a 50% drawdown are like 90% in a developed market, right. You’re investing in France, that French market goes down 50%, you’ve got a 90% chance you’re going to be back up within a year two back up to where you started.
EM drops to about 75%, your chances that you’re going to recover, they’re still good, it’s some good betting odds. But there are a lot of these companies that just go bust and never come back and that’s a risk you’re taking in EM. So that’s been one factor, very frequent crises that just wiped out gains and reset things and there was bankruptcy and slate got cleared, or the market never recovered and it was a big part of the index wave. And those things have been really detrimental to emerging market investors.
And the second is, sort of, more conceptual but relates, I think, to some framework that Perth Tolle and others have been doing around property rights and legal protections and avoiding corruption, and thug-ocracy, and torture and all these awful things that tend to happen in some of these countries, right. And you think your equity might be fine in China, and then you see what happens to Ant Financial, right, and all of a sudden you realize, gee, maybe Chinese equity isn’t all that safe. Maybe the property rights aren’t all that good. Maybe I should be a little bit more worried if that’s happening in China, which is now…I think there are some people saying, well, maybe China should be an emerging market, maybe it’s big enough that we should think of it as a developed market.
But certainly, you know, if that’s China, right, think about the next level down, and it’s just mayhem out there. So I think broadly, EM returns have been pretty disappointing despite great consensus among smart people that they were going to be really good, right, especially…. and I’ll talk about why that consensus is sort of interesting and we should go into that. But they’ve been disappointed. The reason it’s been these crises, they’ve just wiped out folks and really driven returns way down. And so I think thinking about how to navigate those crises, what to do about them is, I think, really important to invest in well in emerging markets.
Meb: Thinking about emerging markets over the past 20-plus years…like almost anything, I mean, today, it’s innovation disruption in a lot of the tech companies. But looking back in SPACs over the last 20 years, every couple of years, you have the new shiny object in pre-financial crisis, the bricks were hot. I mean, you go to any institutional conference, the fangs were the BRICs, Brazil, Russia, India, China, right? Because in the 2000s, emerging demolished U.S. stocks, partially because U.S. stocks finished the ’90s on the highest valuation there ever were. Rinse, repeat, over and over again. And so these things go through cycles.
And at least on the sentiment side today, the vibe, at least on maybe it’s more an individual in retail, I talk about how I put my son’s 529 and my 401(k) entirely into foreign and emerging and people lose their mind, particularly when you talk about emerging, they go crazy. And you lay out some of the use cases and say broadly it’s still attractive. Valuations, demographics, the fact that everyone gets angry. And also, that people are really underweight. I think Goldman had the average stock allocation emerging in the US at 3% versus whatever you want to call the market cap depending on how you weighted.
But part of that, I think, is what you’re talking about, which is you touch the stove enough, you’re not going to go back to the stove. You’ve burned your arm six times on the reputational risk of investing in Thailand or Brazil or Russia, Greece, my God. Greece, by the way, just half the time is in developed, half the time in emerging at some point maybe in frontier, who knows? But talk to us about how to think about emerging markets on crisis and, kind of, where’d you come out the other end?
Dan: That’s liquidity dynamic, Meb, exactly what you’re talking about, is really important understanding EM. So you think about where it is most of the money? For the last 30 years, most of the money that is going to fund company growth, where’s the money that’s going to come in and buy public equity in these stocks? Well, most of it, it’s going to be external, right? It’s going to be someone in New York saying, “Hey, Thailand is interesting. I’m going to go invest and I’m going to fund new construction of a railway.” This goes back to like the British Empire.
And by the way, there were a lot of, like, fraud schemes like, “We’re going to build a railroad in Panama, right, give us the money,” they disappear. The coalmine in Columbia, right. And obviously, today, there’s a long story, right, about hopes and dreams that people have, people have hopes and dreams, the world is going to become a “Popular Science” magazine, or that the thing that they watched that last sci-fi movie is going to become real. And they also hope that some exotic foreign place they’ve never actually been to is somehow going to become a very robust and profitable opportunity they really want to be in on.
And so you see these dynamics, right. And I think the other big thing you have to look at is that there was for a long period of time…after the fall of Soviet Union, there was a lot of politics about emerging market investing. There were a lot of people who were saying, “The Soviet Union has fallen, there’s a global convergence, right? We’re going to have liberalization, we’re going to have the stock globalization, we’re going to have privatization, and we’re going to see this convergence whereby all these developed markets catch up the rise of the rest, and you should go put your money behind this,” right. The World Bank is going to tell you, “Go fund the construction of that bridge in Thailand.”
There are a few, kind of, interesting things about that, right. One is it drove a lot of liquidity flows into these markets. And those liquidity flows actually did drive economic growth, they were beneficial, right. The New Yorkers that funded the building that bridge in Thailand, that bridge in Thailand actually paid off in GDP growth, just the guys in New York didn’t make any money off it. It was good for Thailand, it just wasn’t good for the investors in New York. And so you had this huge push from people like the World Bank and others and the, sort of, chattering classes that you had to be smart, you had to get your money in these emerging markets.
And there’s the old adage that, you know, emerging markets are something that’s sold not bought, right, you know, it’s pushed on people. It’s a good idea, all the experts say it’s a good idea. The odd thing about that, though, is that when the crisis comes, right, and you’re sitting there and never actually been to Malaysia. And I know we have a 2% allocation, I’ve never been there, I know nothing about it. The one thing I read online said the company that we own there is kind of shady, we should just sell it. It’s down 50%, let’s just take our tax loss and get out.
So you have these really exaggerated liquidity flows where everyone is really bullish, and then everybody pulls their money out. And that contributes to a lot of problems in these emerging markets. Like, over the long term, foreign investment is good. But the volatility of that foreign investment causes a lot of problems for these countries. And there’s a whole litany of macroeconomic issues that it causes.
Well, one of the things that happens, right, and again, sort of similar, what we talked about small value during crisis. If you like small value in a crisis, you’re going to really like emerging market in a crisis because the liquidity flows are even more dramatic and even more ignorant, right. If you think of, like that small auto parts company in the U.S. is unfollowed, it’s sort of like the Malaysian equivalent is really not followed. What we found, right, is that let’s separate out two types of crises. So let’s call them global crises.
Let’s define that global crisis, anytime the S&P 500 is down 20%. The S&P is down 20% and Malaysia is down 50%, that is a really good time to go buy emerging because the liquidity flows out of the EMs are not a consequence of saying it’s EM specific, right? It’s not like Quinta has just taken over and expropriated all the assets and you’re fool to put your money in, right. It’s just that investors are panicking and they’re selling the stuff they don’t really understand, and that happens to be a lot of emerging market assets for, sort of, tourist investment for a lot of people, not as a core holding. And so you know, there are these fire sales, right.
And so if you go and buy emerging market equity, especially emerging market value equity, we found that over these emerging market crises, you’re looking at really dramatic, 2 years after a global crisis, the U.S. market was up call it 20%, 25%. Emerging markets were up like 90%. If you were willing to take the risk in March 2020 and go and put a ton of money into emerging markets, that was a really good idea because everybody else was panicking. All those same things we talked about with sort of the earnings rebound and cyclical GDP, right.
Well, emerging markets, they’re sort of at the tail whip of supply chain, they’re providing a lot of the raw materials. And those raw material prices are going to fluctuate really a lot with GDP growth, global GDP changes. And so if you think that the auto parts manufacturer is really cyclical, the company that makes the rubber for the tires is even more cyclical. So emerging markets, in times of global crisis, they’re perhaps the best place to do, sort of, extreme crisis investing, risky, but extremely interesting.
Then you have the idiosyncratic crisis where one country just blows up. Everything else is going fine and Argentina just goes parabolically down, right? Those times actually are a little different. So when we analyze those, what we found is that they actually only had about a 65% chance of recovering, which is really low. The equity market was only 65% chance. So for all crises, global and the idiosyncratic, we were up about a 75% chance of recovery in emerging markets. But if you just do the idiosyncratic ones, it drops to 65%.
So a lot of the times if you go into these countries just after they’ve had a crisis…we define a crisis if there was 50% drawdown in the market. Argentina is going along, every other country is fine. Argentina’s market drops 50%, no other country has experienced anything similar. Argentina has about a 65% chance of recovery, 35% chance…the reason it dropped 50% is some awful thing that happened to the government, or regime change, or property expropriation, and you’re just not going to get your money back. Buying EM in this idiosyncratic crisis is actually not that great of a strategy because there’s really low recovery rates.
It’s just too risky, the problems are often too real and not liquidity-driven, right, which is what you’re looking for, right, the liquidity-driven opportunities, not real information-driven opportunities. But what we found was sort of interesting, right, and this is sort of a broad finding about emerging market, if you look at emerging market debt versus emerging market equity, over the past 30 years, you’ve done better in emerging market debt than emerging market equity with half the volatility.
Simply if you went and said, okay, Argentina, for whatever reason is down 50%, no one else is down, I’m going to go buy their government bonds. That’s actually been a really good trade because you’ve recovered in the government bonds a much higher percent of the time. Like 85% of the chance, you’re going to get your money back. And often the returns are going to be very good because you can buy like that debt at like 20 cents on the dollar, 30 cents on the dollar, 50 cents on the dollar. And when it goes back up to par a year or two from now, maybe they got a bailout, maybe the economy’s recovered, even if the equity market didn’t recover, most often your money got on the bonds and there’s often a lot of upside to buying low par.
So we came up with this idea that in this emerging world, right, you have this, sort of, buy and hold approach. And we sort of said, hey, gee, buy and hold has not actually been that good, in part because these crises and the liquidity issues we’ve been talking about, it’s boom-bust cycles. It’s just a crazy kind of…it hasn’t ended up paying off. But if you were more like a sniper approach, right, you just wait, and you wait until there’s a crisis and then you say, okay, gee, first question, is it idiosyncratic or is it global, right? Is the reason that this Malaysian market is down 50% because investors in New York are panicking about everything, or is it because something really bad happened in Malaysia and only Malaysia?
And if it’s the former, right, if it’s a global crisis, it’s liquidity-driven, go buy equity, go buy emerging equity, buy as much of it as you can. You’re probably going to do really well making that trade. And if you can, buy value because emerging market value does even better. And if it’s not, right, if it’s just specific to that country, don’t take the risk on the equity because you might not get that money back. It’s a 45% chance you’re going to lose more money even though the market is down 50%. What you’re better off doing is buying the debt. And that’s often a very good trade and much more likely to come out ahead.
And so we sort of said is gee, that approach, right, let’s say you just sit in 10-year U.S. treasuries, you’re sitting in cash, and you just wait for crises in emerging markets, and drawdown from that, sort of, central bank to go deploy capital in emerging market crisis. That’s dramatically outperforming the returns you would have had buying and holding emerging markets. And it’s a relatively simple approach.
Meb: Simple or my favorite, and people can think back just even over the last decade, a couple of things that I imagine listeners are mulling over. I mean, they may say, well, Dan, that sounds so boring, that’s not going to have the juice. I mean, if you think about Greek debt post-financial crisis, I mean, that was like a Mount Rushmore trade. Like, you made that trade, you bought Greek debt, you, you don’t have to do anything that was like a career maker opposed GFC.
I think the struggle a lot of people are going to have is say, okay, what do I do about the timing? How do I go about putting this together? If I wanted to think about this, is this something that I’m looking at every day? Am I updating this, like, once a year? How do I portfolio-size these things, am I just going all-in on whatever’s down the most? How do you think about putting it all together into a coherent strategy?
Dan: I think part of it is developing some simple intuitive rules for thinking about it, yeah. One really simple intuitive rule, it sort of builds on our work. Let’s talk about market timing maybe for a second. Market timing is this really dirty word, right, in part because a lot of times when people talk about market timing, they’re saying, “Hey, I think there’s going to be a crisis, let’s sell out now.” And that type of market timing has just a disaster for people. Now, there’s a second type of market timing where the market has just blown up and you say, “Wow, we’re about to enter the Great Depression, let me press sell.” And that’s worked even worse, right. So those are the two types of market timing that are really, really bad and really destructive to investor portfolios.
Now, part of the reason that those are both really negative, right, is that they’re built on sort of this fear-based narrative pessimism in, sort of, the triumph of the optimist’s world, which is equities, right. The other approach, which I actually like, and I agree with, I know this … to talk about market timing, but I do believe that, right in times of crisis, you know you’re in a crisis, right, so it’s not like I think a recession is going to come next year, right? Well, you don’t really know that. And the probabilities really aren’t that good. When you’re in a crisis, you 100% know you’re in a crisis, right? It’s on the front page of “The Wall Street Journal,” your grandpa’s calling you and saying, “Should I sell all my stocks?” It’s just really obvious.
So it’s natural to say, hey, when there is a crisis, I want to have, kind of, a playbook. I, kind of, want to know what the most likely things that are going to happen next are. Yes, I’m an optimist, not a pessimist, what should I be betting on? How should I be thinking through this? And I think there’s sort of a hierarchy, right? You’re sort of sitting there and saying, okay, where should I look? Now I know that we’re in March of 2020, I’m sure we’re in a crisis, I’m sure everything is going to pieces, what should I be thinking about? What should I be going through my mental checklist of opportunities?
And I think this piece, this emerging market crisis paper that we wrote, one of the big things it highlights is emerging markets should be at the top of your list. You should be thinking if the S&P is down 20% there are so many people right there that buy less. So like, okay, Amazon is a company that I really want to own. So if Amazon ever went down 20%, I would buy it. And you’re also saying if Amazon is down 20%, right, you should be pretty confident that, like, Indian stock market is going to be down like 60%. And you’re actually going to do much better going and buying the Indian stock market than you are going and buying Amazon. I think that’s a really good, sort of, checklist.
So you know, you’re in a crisis, you should think emerging market and especially emerging market value because the value stuff, for the same reasons in the U.S., the value does better than growth. And then in the U.S. and developed markets, small value, right, those things are the things that tend to rip very reliably out of this global crises, right. So if nothing else, that’s sort of the key, sort of, simple takeaway, right? That in crises, if you want to earn excess return, you know you’re in a crisis, you have cash deploy, God willing, right, go buy EM value, go by small-c, a especially small value. And you’re going to earn a lot of excess return for taking on a lot of risk and for very rational liquidity-driven reasons, right. There’s liquidity flight from emerging markets, there’s liquidity flight from small value, you’re able to buy stuff that other people are panic-selling for no good reasons other than it was a tourist non-core investment in their holdings and they’re trying to liquidate.
So that’s, I think, the first takeaway, right, which is sort of simple, very high-level heuristics level. Then I think there’s where it gets, kind of, complicated where it’s a little bit more difficult is sort of thinking through these idiosyncratic crises. Malaysia blows up and nothing else blows up, or Chile blows up and nothing else blows up, what do you do? And going and buying Chilean debt probably isn’t something that a lot of us are going to do. That’s probably something that you’re going to have to hire someone to do for you if you want to do it. I think it’s a pretty interesting trade, but it’s probably too complex for a variety of reasons to do at home. But I think for anybody, you can go buy EM value stocks in the middle of a crisis and that’s, sort of, the most simple and most obvious answer.
Meb: If people want to get crazy, a lot of these individual countries are even more bananas, you mentioned Argentina amongst others. But there’s the old investing adage, you know, what do you call something down 90%, something down 80%, then went down by half afterwards? And so that 50% marker sounds like a lot. But in some of these, I mean, my God, if you look back in the history the last 10 years, I mean, Brazil essentially went through like a great depression. Greece has essentially fallen under the Mediterranean, yadda, yadda, on and on, right? Should most investors think about it broadly speaking, as you mentioned emerging value? Should anyone dabble into these individual countries? And then lastly, you got to throw this all in the bowl of cereal is, how should they think about currencies in this mix too? Should they hedge them out? Should they not hedge them out?
Dan: So this Professor at Yale, William Goetzmann, there’s a company called Global Financial Data. And what Global Financial Data does is they string these really long time series together, right? So like, you can look at the Mexican stock market back to 1700, or the U.K. stock market back to like 1400. It’s really cool how they do it. And William Goetzmann of Yale went and said, “Gee, I know there are a lot of research on bubbles, but what about negative bubbles? What about times when markets blew up and there was a panic? Where those good buying opportunities?”
And what Goetzmann found…I think his data set is now starting in the 17th century. So from like, 1690 to the 2000s, what are sort of the empirical realities and negative bubbles as he calls them? And what he actually found, you know, to your point is that a 10% drop was not enough, right? Like, a 10% drop, that’s more of a trend following, drops 10%, like maybe you should sell. Drops 20%, maybe you should sell, right, there’s sort of a trend dynamic there.
But once you hit 50%…that was, sort of, the magic number in his research. Once you hit 50%, you had what he calls a negative bubble. And negative bubbles are such attractive buying opportunities. And for many of us who are long-only or long-biased, what you’re really looking for is negative bubbles, right? You know, how do you deal with a positive bubble? That’s another can of worms, but you certainly know what to do in a negative bubble, right? It’s sort of what the rational, historically-minded, thoughtful person knows, right? When something blows up and blows up way more than it should have, you should go buy it. When people are panic selling, when there’s blood in the streets, that’s a good time to buy. And I think that Geotzmann found that’s over a very long period of time, like back to the 17th century, the right answer. So that 50% threshold is, I think, a really important one.
And we sort of looked at it two ways, right. We looked at creating an index of countries based on which ones were down 50% or more, or by just buying the emerging market value index, and it’s the same outcome. It’s been basically the same stocks so they’re, sort of, indistinguishable, right. But I think what you want to be cognizant of, right, is just making sure that, sort of, global versus idiosyncratic crisis concept is, I think, important, right. If your favorite market is down 50% and the U.S. market is down 20%, by all means, load up. The U.S. market is chugging fine, and your favorite market is down 50%, step back and say, hey, wait a second, maybe there’s a pretty good reason for this. Maybe my odds aren’t as good here as they would be if the reason for the down 50% is that there’s a global liquidity crisis, not that there’s some real specific informational content that was going on in this market.
You know, another way to, sort of, think about that, right, is often there’s a down 50% after a big bubble has burst. So down 50%, you know, in an idiosyncratic time might actually just be coming back to fair value from a really exaggerated overvaluation driven by foreign capital inflows pumped up by promoters in the U.S.
Meb: It’s kind of getting at the same concept from different angles that I think is really thoughtful. The cool thing you mentioned Global Financial, we had the founder on the podcast. I think Brian’s coming back on. But there’s plenty of other sources of free research if you’re listening, listeners, like French Fama data. We’ll add a show note link, we have a host somewhere, I forget where, that lists a bunch of free data sources. But you can take a lot of these back to the ’20s, maybe not to the 1700s like the professor.
But the cool part is that you can examine a lot of different ways. We have some old studies they’re like a decade old, I mean, in my first book. And these are like, kind of, like magazine covers sentiment style. So we just like you got a big asset class, what happens when it’s down multiple years in a row, like three years in a row? With the theory being is that people are so sick of opening their statements after a couple of years that they’re going to sell. But also, you’re just getting this mean reversion of fundamentals probably and so not surprisingly, the returns are great.
Ditto if you buy things down 60%, 80%, 90% and you got to adjust this, of course, listeners, if you’re buying a tiny industry, or a tiny country, like Czech Republic versus buying, say, emerging markets or something like U.S. debt. But the whole thing comes with like the close your, eyes hold your nose, sort of, concept to where it’s probably going to feel nasty, and it may go down even a little more. But often that’s been rewarded over time. And a simple way to do it if you’re not that brave and bold and crazy as Dan is to simply just rebound, that naturally gives you the moving back towards center on whatever you’re allocated to. No unknowns in the emerging markets anyway, but if you did, it would be moving back. Forex, how do you think about that? Do you think about it?
Dan: Generally, you know, obviously, Forex is really volatile in these countries too. But the rates that you have to pay to hedge some of these EM countries are so prohibitive. You just, sort of, stuff it and take the local FX exposure if you’re buying at the right time because otherwise, you’re just paying too much and it hurts your…to try to hedge
Meb: Do you guys run this as a strategy, by the way? Is this something you guys are putting to work?
Dan: We don’t today, but I think we’d like to implement it. So we’re working on that and we think it’s a really interesting approach. And the challenge to it, right, is I think you have to sort of pair it. A lot of this crisis investing if you think about it, right, it’s like, oh, yeah, it’s a great thing to invest when the market is down 50%, the U.S. market is down 20%. The problem is who has the cash, where’s the money going to come from? So when the market is down 20% a lot of people are feeling a lot of pain. And there’s a liquidity crisis for a reason, which is like, hey, everybody starts withdrawing money, right?
So how do you, kind of, have the capital ready to go? Or how do you have capital that you were really conservative with in good times such that when that tremendously good opportunity happens you’re the one with money? I think Seth Klarman is, sort of, like my mentor role model here for this. You think about Seth’s career, he’s had long periods of time where he’s dramatically underperforming the market. The ’90s are a great example, Klarman is just getting crushed, right? He’s out like 2% or 3%, or whatever, and the market’s up like, 60%. And people are saying like, “Why are you buying tech stocks? What are you thinking?” He’s like, “I have 40% of my portfolio in cash.”
And then the market blows up and you get this, sort of, like once every 5 or 10-year opportunity, and Baupost is going deep into value stocks, deep into the stress debt, right. I don’t think they do international anymore. But like if you think about that type of approach where you say, hey, what I want to be doing is, sort of, something really conservative when everybody else is exuberant, right. It’s the Buffett quote, right? Like, how do you actually implement that? Like, what would you actually do that would be conservative such that when everyone else had a 30% drawdown, you had a 10% drawdown, and you hadn’t been paying out massive hedging costs in the interim such that when these emerging market opportunities presented themselves, you were the one with cash, right?
And so what I have been, sort of, thinking about, there’s sort of two ways to do that, right, you can sort of say, hey, I’m going to tell you guys all about this, and like, give me a call when the market blows up, and I’ll help you put your money to work in EM value, which is one sort of approach that makes sense. And we’ve done that in U.S. small value and I think that’s a really great approach and it works. But I think the other way, and maybe the way better suited for the EM opportunity, is trying to think about some way to be countercyclical, right, to be conservative when everyone else is excited. And like Klarman, be really effective at communicating that that’s the purpose of what you’re doing. There are extraordinary market opportunities, negative bubbles create extraordinary market averages, create like generational wealth, but you got to have the money to deploy at those times. And those are the times that no one else has money, you sort of think of why you’re being rewarded.
I love that thing that you did about three years down. The three years down thing, it’s so brilliant because it’s marrying psychology. It’s people looking at their statements, and you’re just thinking real-world like, oh, that investment committee I’m on, or like, my own money. Like, instead of one year it’s like, okay, two years, you’re like, “Oh, my God.” Three years, you’re like my thesis was just wrong, it was wrong. Like, I can’t just revisit my thesis and ever imagine that I can tell somebody that my thesis was right, right. Clearly, my thesis is was wrong, it’s been down three years in a row. And there’s a real psychological impact there.
And I think these negative bubbles are one of those classic examples where you can capitalize on that, and the opportunity is real. And it’s real for psychological reasons, you just think common sense, of course, it’s real. And then if you pair that with illiquidity, right, and you say, hey, let me look for the markets again where people are tourists, they’re core holding. No one’s core holding emerging market stock, no one’s core holding a small-cap value stock, they have a 5%, or 10%, or if they’re really adventurous, a 20% wait. But that’s not stuff that they feel core to what they’re doing. And as a result, when they have three years of bad statements, they press the sell button.
And if you’re there with capital when no one else is in these tourist investments they are actually good investments, but you’re the one with capital, buy them after those three years, after the drawdown, you’re going to come out ahead for very logical, very rational reasons that I think are very much in line with both academic research and market psychology lived experience, but you got to have the capital. Thinking through that problem and how to do these things, whether to do that in the opportunistic way with drawdown vehicles, or whether to do it sort of in a full cycle approach like Klarman, I think those are, sort of, really interesting questions. But they get to the root of, you know, what makes investing challenging, sort of psychology and the nature of cycles, and the challenge of finding a countercyclical way to deploy capital, which is just much, much harder than it seems on paper.
Meb: I have a better solution, Dan, are you ready? All these big institutions peel off their private equity deals as they get liquidity, and they just put it in a sidecar and they reallocate in emerging market crisis, I mean, come on.
Dan: Meb, I know you’re half-joking, but maybe more to the point, right, because this comes back to my original thesis about private equity, right. And one of the things I found really early on about private equity, which is really fascinating, is private equity capital deployment is very pro-cyclical. And if you think about why it’s pro-cyclical…and by pro-cyclical, I mean, they invest more when the market is expensive and less when the market is cheap, just sort of the opposite of what you want to do.
As for your capital calls are like, correlated with the S&P 500. The S&P 500 is ripping, you’re getting a lot of capital calls. The S&P 500 drops, your capital calls drop, right? And you’re like, wait a second, right like, shouldn’t a rational investor deploy more capital when things are cheap and less capital when it’s expensive? And because private equity is taking money and putting it in things, right, it’s not like the stock market where it’s buy and hold and you’re looking at, sort of, liquidity flows in and out, right. It’s literally like they’re calling capital, right, so you can really trace that.
And one of the reasons for that is that when a private equity firm goes and buys a company, they’re putting 40% of the money down, and 60% of it is debt. So they need the lender, the lender has to be there. So if you’re in the middle of a liquidity panic, well, what’s the lender doing, right, that’s the high yield spread. The lender is saying, “No, absolutely not I’m funding that. If you want the 10, you’re going to pay 600 bips over,” right. And the private equity firm is like, “Oh, that doesn’t make the economics of my deal work. My deal only works when I get cheap debt. If I have to get expensive debt, then the lender is going to make all the money and I’m not going to make it,” right.
So if you look at how cyclical PE deals…and by the way, the private equity firms, they always talk about the importance of control, right, we control our companies, we sit on the board. Well, what that means is when crap hits the fan, all your deal team is going into the company they bought six months ago to try to save it, right? They’re doing, like, weekly cash flow things for the management team, and like, how am I going to meet my debt covenants? And, gee, let’s get our capital markets person to call the private credit people say do not, absolutely do not force us to pay interest this quarter. All the private equity firms they’re totally distracted by their portfolio, and there’s no debt.
And by the way, like, think about you’ve made this really awesome company, it’s your family’s legacy. And, you know it’s a great company, it has like 20% return on assets, and it’s just a killer. And you decided grandpa just died, you’re going to sell it, you call KKR or you call up Goldman, they ran an auction. And then all of a sudden, the S&P 500 pukes 20% 30%, right, we’re saying March ’20. What family, what reasonable person is going to say, “Hey, should we hold off on the sale process, maybe we’re not going to get a good deal from KKR in March of 2020? Maybe we should wait, let’s just push the sale, push the auction back.”
So all those dynamics mean that allocators who are relying on private equity for a large component of their investments are having massive pro-cyclicality in their cash flows. And that’s a problem and what they should be doing, and I think to your point, which is totally dead on, they should be saying, “Hey, public markets are really uniquely attractive relative to private markets at these times. And even if private markets were attractive, I can’t find any money to work there, so no deal is being done and no capital calls.” So if I want my capital deployment to be steady and not big dips when the equity market takes a dip, I got to find a way to plug that hole.
And I think thinking through whether to do that with small-cap value, or private equity replication, which I think is a fantastic idea and one we’ve implemented to great success, or I think even to take the risk level and hopefully the return level to next level and do it in emerging markets, I think it makes so much sense. Now, can we convince people to do that? It’s rational, it’s logical. But I think the challenge to it probably is that you’ve got to find people that aren’t so constrained by their style bucket for this, “I have a 20% allocation of private equity and public equities are not private by definition, and therefore, absolutely not.”
But I think people that are a little bit more creative and saying, “Well, what I really am thinking about is drawdown vehicles as a type, or I’m really thinking about lockup vehicles as a type, whether that’s public or private, and maybe distressed debt fits in. And I think a more, sort of, holistic or creative approach would work. And I think it would really improve the results for…” Again, I don’t think you should be allocating a lot of private equity, but if you’re allocating a lot of private equity, you’ve got to be aware of this pro-cyclical problem and the fact that your capital calls really dry up in times of crisis.
Meb: I think that’s really important instructive on a couple of levels, thinking about…we talked a lot today about flows, but also about structural and behavioral reasons why these things can reinforce. And on the flip side, back when we did these old studies, and again, they were meant to be simple but when you looked to the big asset classes were like three years down a row. But when you expand it to countries or industries, much smaller, much more volatile, you had some that could end up being down three, four, or five.
There’s only one industry in the history of the database that I remember that went down six years in a row, and it did it twice, and that’s coal stocks. And this happened a few years ago. And more interestingly enough, the only way to invest in the coal sector was a coal ETF, which just closed. That’s an absolutely abandoned asset class, totally uninvestable from ESG, everything.
Dan: There is nobody wearing a blue shirt in a room with no books in it that owns coal stocks.
Meb: You guys need to watch this on YouTube because Dan’s waving his hands. Uranium was another one. And we used to do these end of year comments where we say, look, what’s been the absolute most hated thing, whether it’s years in a row or down the most. And it’s been a lot of the commodity sector. It’s been a lot of the ag sector. But by the way, I spent way too much time with my hands in the dirt in the farmland in ag world, but things seem to be picking up there, whether it’s due to inflation, whether it’s due to macro things going on might be an interesting place to look, listeners. But emerging also seems to benefit from some of these dollar and inflationary commodity moves that we’ve been seeing.
Dan: I feel like most of the stuff you read about EM is, like, very promotional, right. EM is the best, you know, global convergence, right, global privatization, liberalization, right. I wrote this whole 50-page thing, it was really kind of dark about emerging markets. It’s sort of like, I don’t know, emerging markets, kind of, you know, where the long-term buy and hold, it doesn’t work. And I feel bad because I published it at the time when actually the whole paper was saying buy emerging markets. It’s got sort of like this whole tone of like, be really careful, these things are bad.
But I published it at a time that actually, I think emerging markets might be one of the best opportunities out there. I’m like, you sort of rank the value opportunities out there right now you’re like, okay, I think probably Japan, probably the U.K., and emerging market stocks. Those are probably like the big three for me right now. And then I think you’ve got the, sort of, small value recovery in the U.S. and those are the trades I think are really interesting right now. But it’s, sort of, ironic that I published this hugely negative piece about EM at a time when I actually think it’s an awesome opportunity.
Meb: You’re not going to have to wait long if you’re waiting for a crisis somewhere in emerging markets usually, something is going off the rails. And so listeners, you want to fund Dan’s new emerging market crisis strategy, he promised he would give listeners the show a discount on the carry. So if you give him $10 mil…the problem is, it’s a $10 million minimum, so hit him up after this and reach out.
Dan, as you look out to the horizon, you guys have been cranking out research. Anything else on your brain that’s got you thinking…your sleep-deprived, new child brain that you’re thinking about brainstorming about, curious, worried, excited about?
Dan: I think it’s really the questions we’ve been talking about today which have really…you know, I think by coming from private equity and moving to public markets, right, and saying, okay, well, private equity, just, kind of, constructed with leverage and size and value, right. You got to, kind of, start doing it, you’re like, holy smokes, the public markets are volatile. I personally am a really calm person, I don’t get like, really anxious so like, market’s really volatile, it doesn’t really affect them, which is nice. But I see how much it affects other people, right, and then I’m like, okay, gee, there must be something to this volatility thing. And I start researching, like cycles, crises, boom-bust.
And you start to realize the excessive volatility of markets is just like one of the defining things you have to know about equity markets, have to know. They have to think through how that affects people, and how that affects the investor, and how it affects investment. And I think this whole question has become so fascinating to me of like, if you know you have a good idea, you have this idea and you know what’s right, and it’s a question of, as much as I don’t know what will happen and when it’ll happen and you’re trying to figure out the when.
And I think that the volatility of markets really is something that helps you think through the when, right, and trying to conquer the when, the market timing questions. And how do you think about the relationship of that to macro? And how does that relate to crises? Going back to those times when there’s not a crisis, right. I actually think the crisis playbook is pretty straightforward, okay, I think it’s pretty obvious what to do in a crisis. And these things are pretty predictable. And academic studies will tell you that, my work will tell you that, your work will tell you that, right, like things are down three years in a row, it’s just a pretty good idea. The hard part is actually doing it, and finding the money to do it, and having the money to do it, and taking that psychological leap to do it.
And so I think that’s the sort of set of questions I’ve been working through, exactly what we’ve talked about, right. How do you have the capital to go and exploit this crisis? Where does it come from? What should you have been doing with it when you were waiting for a crisis that didn’t just like burn a hole in your pocket because you’re buying, like, awful hedges that didn’t make any money or something, right? Like, what’s something rational to do that’s conservative? How do you then go and mix and match some of these interesting crisis opportunities? How do you match emerging markets and small value? How do you size them? All those things have been really the things that I’ve been thinking about.
I’d say if there’s phase one is figuring out what made private equity work. And then phase two is, sort of, figuring out how to deal with volatility and booms and bust cycles. Right now, I’m really interested in comparing those two things. Also, some sense of understanding the macroeconomy and how volatility relates to what economic regime we’re in. How the economic regime we’re in relates to how small value does, and I think that’s a lot of what’s been occupying my mind. And hopefully, if you’re a subscriber to my weekly research, or hopefully in 2023 when I come back on the podcast we’ll be able to talk about some interesting findings in those regards.
Meb: You’ll probably have three more children by then, we’ll be doing it by a hologram, and hopefully some books on the bookcase. Listeners, he doesn’t have a single book on his bookcase, so send Dan some books. One last comment I think that we talked a little bit about this but I think is important, you know, so many investors when they think about topics like a new asset class or when to allocate, they stress so much about wanting to be all-in or all-out as if it has to be this single binary decision. And we often tell people, look, you can think in terms of a spectrum, of position sizing, it can be small, you can scale in, you can scale out. That’s more boring for a lot of people because they don’t have something to cheer for.
But in many cases, I think is a thoughtful way to go about it so that you’re not, as we know, dealing with regret minimization all this time of, “Hey, I bought Argentina, and then it went down another 50%, dammit, why didn’t I wait?” Or whatever it is, you know. So maybe think in terms of units bought a half unit, I can buy another half unit based on these rules. Anyway, things to think about. Dan, where do people follow you? Where do they, go keep in touch of your emails and new research pieces coming down the pike?
Dan: Yeah, I’m on Twitter @verdadcap, verdadcap.com. Both those places have sign-up lists for our weekly emails to come out every Monday. And I promise that they are provocative if nothing else.
Meb: Awesome, Dan, thanks so much for joining us again, buddy.
Dan: Thank you, Meb.
Meb: Podcast listeners we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at firstname.lastname@example.org, we love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.