Episode #505: Que Nguyen, Research Affiliates – Walking the Tightrope: High Valuations in an Inflationary Landscape
Guest: Que Nguyen is the CIO of Equity Strategies at Research Affiliates. She leads the cross-sectional equity research and strategy design that supports the firm’s systematic active portfolios and smart beta indices.
Date Recorded: 10/11/2023 | Run-Time: 42:35 
Summary: In today’s episode, she shares why stretched valuations along with a rise in interest rates and inflation may create a tinderbox for investors. But not everything is gloomy – she’s sure to share some areas she sees opportunity in the U.S. market today. We also discuss the ‘Magnificent Seven,’ fundamental indexing, and where she sees the dollar going from here.
Sponsor: Vinovest is a wine and whiskey investing platform democratizing access to these ‘liquid’ assets. With more than 150,000 registered users, Vinovest has made it easier than ever to buy, sell, and store high-performing wine and whiskey.
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Links from the Episode:
- 1:09 – Welcome Que to the show
- 1:29 – The Magnificent Seven stocks in the S&P 500
- 5:57 – The merits of fundamental indexing as an investment strategy
- 12:37 – How investors should be thinking about the macro forces prominent today
- 20:39 – Forecasting the future path of interest rates
- 21:25 – Integrating the energy sector into the macro world
- 24:47 – Why sectors are becoming more stable through time, and the dollar gaining strength
- 27:07 – The Asset Allocation Interactive
- 28:46 – Contrarian views not commonly held by Que’s colleagues
- 33:17 – Non-market capitalization, evaluating quality, and the importance of capital discipline
- 37:56 – Que’s most memorable investment
- Learn more about Que: Research Affiliates
Transcript:
Welcome Message:
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Disclaimer:
Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb:
Welcome everybody. We got a special episode. Our guest today is Que Nguyen the CIO of Equity Strategies at Research Affiliates. In today’s show, she shares why stretched valuations along with a rise in interest rates and inflation may create a tender box for investors, but not everything is gloomy. She’s sure to share some areas she sees opportunity in the US market today. We also discussed the Magnificent Seven fundamental indexing and where she sees the dollar going from here. Please enjoy this episode, Que Nguyen.
Que, welcome to the show.
Que:
Thank you.
Meb:
It’s been, as always been an interesting year. We might have officially re-crowned Research Affiliates as the number one poll position as far as podcast alums on the show with you joining us today. So welcome. But where do we begin? What do you want to talk about? Do you want to start with your overall view of the market should talk about the Magnificent Seven? Where should we start this fall, October day?
Que:
Sure, we can talk about the Magnificent Seven certainly. I mean, those stocks have been truly magnificent. They’ve accounted for about 50% of the increase in the S&P 500 this year. That’s great returns for our investors, but the problem is that it causes a very much of a narrowing of the indexes. And so now when you’re owning the S&P 500, you’re increasingly just getting exposure to those stocks. And so if you’re looking for diversified exposure, you’re not necessarily getting it and the cap-weighted indexes anymore. So I think that increases risks for investors going forward. You’re increasingly owning more and more expensive stocks and less and less of cheaper stocks and you’re getting less effective diversification. So one of the things that we’re seeing is investors kind of looking around and saying, “What are some alternatives to that? What’s a better way of owning a more diversified portfolio?” And I think that’s really the opportunity going forward for investors.
Meb:
I think the commentators would usually quickly say something along these lines, well, isn’t that always the case? Aren’t market cap indices always a little top-heavy? Is this something unique in history? Are there some similarities? Has this got a late ’90s vibe or is this something that is totally unique in time?
Que:
I would say that this is not quite the late ’90s vibe in terms of the market peak of 2000, but it’s definitely getting there. So from that perspective, you do have to be careful. I think that there is a lot of room for concentration, but when things get overly concentrated, particularly when things get very stretched in terms of valuations and interest rates are going up and inflation is on the rise, then I think that creates a tinderbox that could not be good for investors.
Meb:
And so as you think about this one solution is certainly to move away, I doubt your takeaway is going to be like, all right, go short these seven, maybe it is and write them down. But what’s the best alternatives? Because I think some people may have said this earlier in the year too, where, “Hey, look, the broad markets are still kind of on the expensive side, top-heavy, and here we are with these seven ripping and roaring.” What is the alternative? Where should people be going?
Que:
Well, I think there are really two types of alternatives. The first is you go to an alternative index. So something that isn’t quite so concentrated in the top stocks. For us, I think that the history of the Fundamental Index or RAFI is really hard to beat, right? It’s very, very compelling. It’s not a situation where you say, let’s sell these expensive stocks, let’s short them. Let’s just not own them. Rather, what we recognize is that what you want to own is a very broadly diversified set of stocks, but what you don’t want to do is get overly concentrated. And so even in RAFI, we will own these seven stocks just not in the weights that you see them in the S&P 500. And one of the nice things about that is that yes, you do get to participate in their run-up as you would in many, many other stocks, but as they run up, what you do is you rebalance back to their fundamental weight. And so that constant rebalancing the discipline of selling high and buying low is actually what creates better returns for people over time.
Meb:
And I think most investors will be familiar with the Fundamental Index, but we often talk… We talk a lot about market cap weighting to audiences in this podcast. And I imagine if you polled the majority of investors, particularly retail, my guess is that they would think index investing is fundamental investing the concept that you guys talk about. I doubt most individual investors would say, actually market cap weighting is priceless stock time-share is outstanding. I think they would assume there’s some fundamental real world component to it, and they of course, would be wrong. Maybe tell us real quick the overview of what fundamental indexing actually is and why it’s a better way.
Que:
So the fundamental index really started in the aftermath of the tech bubble. And at that time, Rob Arnott, who is the founder of Research Affiliates, was talking to a friend of his at the Commonfund. And what they said is that our mandate is to invest on behalf of these large pensions. And because of that we have to invest in certain indexes. But we know looking at the S&P 500 that there are all these stocks that are ridiculously valued, right? Qualcomm at the time, Yahoo at the time. And yet we own larger and larger quantities of these stocks and it just doesn’t make any sense. It creates a lot of risk. And so if you are designing an index on a clean sheet of paper, how might you approach it? So Rob at the time with his research assistant looked at it and said, “Well, what if we weighted stocks not by their market capitalization but by sales.” Right?
So if you weighted everything by sales, how would it perform? And they ran historical back tests of the US all the way back to 1968. And what they found was it outperformed the market cap index by about 2% per year, which is significant. And so they said, “Oh, sales is interesting, so let’s try something else. Let’s try book value.” And again, they found that it outperformed by 2% per year. And so they went through and they tried a whole bunch of different metrics. They even tried non-financial metrics like number of employees. And what they found is that regardless of what they chose, the outperformance was always around 2% per year. And what they concluded from studying this is that it didn’t really matter what you weighted the stocks by. That’s not what was creating the 2% per year. Rather, it was the discipline of selling high and buying low.
And over time, that mean reversion and the discipline of selling high and buying low adds value. And so if it doesn’t really matter what you weight the stocks by, then what you should do is you should weight it by something that is stable that is not price related. So you have the rebalancing opportunity but at the same time, creates capacity and creates low transactions costs. And so you do want to own the larger companies in larger quantities because they are more liquid, they’re easier to trade, they’re easier to own. There’s a huge amount of capacity in them, but you don’t constantly want to pile into them as they run up more and more. You want to be able to just rebalance back to something that is fundamentally anchored. And so they chose the fundamental metrics of sales, book value, dividends, and nowadays, we include buybacks and then cash flows. And what they did was they said, this makes sense because large companies have large sales and therefore you want to own more of them. You just don’t want to pile into them and then forget about what happens to the price. You want to create this constant anchor, this constant rebalancing and therefore reap the benefits of that over time.
Meb:
And so as you think about it, I think one of the struggles for many investors is they always are hearing the narratives of what you should be doing now, why this is important. And very clearly it does seem like these big names are expensive and they’ve had a big run and it makes sense to move to something like a Fundamental Index. I think the struggle for so many is they then are like, is this something I commit to forever and able to withstand the ups and downs or am I going to… Two years from now when these expensive stocks are down, resist the lure to move in and out? And I think not having that investing process is so problematic for many, we’ve been saying something similar as value. We’re like, look, value we think is always a great idea, but it’s particularly good idea right now. And I don’t know if you have any thoughts about how you think of implementation as you talk to investors that are moving away from what may be a traditional market cap focus, are there any kind of best practices or things you guys tell them as they consider a partial or full switch away?
Que:
So the Fundamental Index can be approached in two different ways. It can be an approached as an alternative to market cap, but when you do that, one of the things you have to be aware of is that in order to reap the benefits of this, you have to have an extremely long holding period. And there will be times when you do really, really well and other times when you give up your gains, right? And so if you want a really smooth ride relative to market cap, you may not get that versus using RAFI. And so if you don’t have that extraordinarily long timeframe, then the other way to think about it is as a value exposure. So if you think about market cap, you can divide it in half, you can say half is value stocks, half is growth stocks. And one of the things that’s interesting about the Fundamental Index is that in… Even shorter time periods, what we’ve seen is that the Fundamental Index is a better value solution. It outperforms the Russell 1000 value. It consistently ranks in the top quartile of value funds. So you can think about it in either way. Just keep in mind that if you’re using it as a replacement to market cap, your holding period should be very long.
Meb:
Yeah, I think that’s true with just about it. Any asset or strategy, there’s a quote we have on our Twitter quote of the days, and I think it was from Professor French where he’s drawing inferences from one, three, five, even 10 years is crazy on some of these active strategies. You mentioned early on a little bit of the macro environment. We’ve heard Rob say before, “Hey, we might print five plus percent inflation by year-end.” I think that would surprise a lot of people. What do you see as the macro forces that are washing around today? Is that an outcome that you think is possible and how should investors really be thinking about it?
Que:
I definitely think it’s possible to get 5%. I think what we saw was inflation was up at like 8%. It trailed back down to something with a four handle, a three handle, but most of what was happening in the last few months has really been the fact that they have much easier year and year comparisons, right? And in fact, if you look at PCE or core PCE, which is the fed’s preferred measure, it still has a four handle. And so as those easy comparisons roll off, could you get to something with a five handle? Yes, you could. But it’s also pretty clear that as those easy comparisons roll off, you’re not going to have the trailing down of inflation that we’ve had in the last few months going into year-end. And I think that beyond that, what happens from here is a big question.
I think what the fed’s really worried about is the classic wage price spiral, right? And so you have inflation, people want higher wages, she feeds into higher inflation, so on and so forth. They need to break that. And that’s the real question is, is this inflation and the labor markets going to feed into a higher wages? I would have to say that I am as surprised as anybody by the resilience of the labor market. I mean, the prints that we’ve seen in terms of labor statistics have been robust. And so the concerns of the wage price spiral are not unwarranted.
Meb:
And so let’s say it sticks around. Why is that a concern as far as markets? What markets become particularly vulnerable?
Que:
Well, higher and higher rates certainly I would say hurts the speculative pieces of the tech market. So the companies that are trading at high multiples relative to sales but don’t have great current cash flow or earnings, right? Those are the stocks that it will hurt the most. It may also hurt companies that are forecasting very, very strong growth rates because now you have to discount that growth at higher and higher interest rates, and it will tend to also hurt companies that are highly levered. Now, that tends to not be in the tech world, but if you’re looking at different types of markets, I think the highly leveraged stocks could be very vulnerable in a higher for longer rate world. I think that the stocks that it tends to reward are companies that can adjust their prices to meet their higher input costs. It’ll also tend to reward companies that are very cash flowing, right? And who don’t have a lot of debt. And so some of those companies will be your classic value companies, and some of those companies may be what people think of as growth, but really just quality companies.
Meb:
There’s an old article that you guys had done where you were talking about kind of the broad market valuations and cap ratios and how they tend to be much lower when inflation is above, and I’m just picking a number in the sand, but call it 4% or 5% or whatever it may be. And on aggregate, they’re still pretty high, which is something that as we get longer and longer in the cycle of this past 10, 15 years, I hear more and more reasons why this is going to always be the case. We’re always going to have these valuations where they are. And it’s a lot of professionals where I hear this from where it’s not just like, oh, well this time is different. Here’s why, it is a full acceptance of this is the structural reasons. There’s so many more people investing in and on and on. Are you sympathetic to some of those arguments or is that something to be wary about when people start justifying these lofty evaluations for a long cycle that’s been enduring for 14 years?
Que:
[inaudible 00:16:57] question, right? Is this time really different? And I’ve been hearing this for 25 years, and one of the things I would say is that in each cycle when somebody says, “This time it’s different,” there are things that turn out differently and then there are other things that don’t. And so why does that happen? What is going to be different? What’s going to be the same? I think it’s going to be a mix of both, right? There are going to be things that are different. There are things that are going to be the same. I just don’t think that higher interest rates can coexist with extraordinarily lofty valuations. But having said that, one of the things I would point out is that very similar to what was going on in 2000, the valuation dispersion within the market is enormous. So when you look at the S&P, we already talked about the Magnificent Seven, how big they are in terms of contribution to the S&P returns, they’re a huge contributor of the S&P valuations.
Valuations of the S&P are in the twenties largely because of these stocks, right? I mean, Nvidia itself is trading at… I don’t know a hundred times or something, but if you were to look at value indexes, whether you look at RAFI or whether you look at Russell 1000 value, the multiples are in the mid-teens, right? And I’m not saying 15, I’m saying 13, which is extremely reasonable relative to 5% interest rates, and we’re not even at 5% on the 10 year yet. But that is at very, very reasonable level. So you can actually say to yourself, do I want to own the really, really expensive stocks in the face of higher interest rates or do I want to own something less susceptible to that? And if you want to owe something less susceptible to that, you have a lot of choices. So that’s one of the things that I see.
But the other thing that I also see is that these days, you have these stocks that have extraordinary economic moats. So whether you’re looking at a Google or a Meta, these are companies that have significant free cashflow, Apple as well, significant free cashflow, significant economic moats, which make it difficult to compete with them. And the only way that competition against these companies is going to happen is really by increasing scrutiny and regulation. And we’re beginning to see that, right? We’re beginning to see that in Europe. We’re beginning to see that in the US. I’m not saying we go in there, we break up Meta or we break up Google, but just the scrutiny adds some restraint to their behavior, allowing for smaller companies to come up and compete. But it’s very, very difficult. And these companies with high free cashflow, with high moats, they will always be valued at a premium. It’s just the question is, should it be this much of a premium that we’re seeing?
Meb:
Yeah, that’s always the case. I mean, Uncle Warren’s been talking about this forever about value investing and look, their largest holding is a giant tech stock or consumer stock I guess you could say with Apple, but they always talk about the valuation of… Is relative of course, to the growth and what’s going on with the business and moats and all these good things you mentioned. I’m not going to hold you to this and neither will the listeners, but one of the hardest things to forecast of course, is the path of interest rates. Is it something you’re thinking about whereas you look out a year or two from now, what’s sort of your base case?
Que:
You know what? I don’t think we’re going back down to two. And if we do go up to 10, it will be an indication that the Fed has done a really bad job. So I tend to think that the Fed is pretty competent, that they’re not going to fail. And so I think that as you look at a year from here, I think we’re going to be at 5% plus or minus one and a half.
Meb:
Yeah. Let’s walk around the macro world, energy is back in the forefront with a lot of geopolitical events as it sort of always is, and it’s been all over the place the last few years. Is that something you guys really think about on the macro side as far as what’s going on there and any thoughts on that broad landscape?
Que:
Energy is really interesting because it’s one of these categories where investors really moved away from investing in it, right? There’s the big divestment movement over the last few years, all the ESG work that’s happening in Europe, and it got really, really cheap and set itself up for a giant rally, right? Because everybody’s gone out, things couldn’t possibly get any worse. And because there’s so little capital pursuing it, the returns have been enormous. Now we think that energy continues to have a role in everyone’s portfolio, and we’re going to lean into it when it’s out of favor and we’ll start leaning out of it when it starts to outperform. And so, I think that if we were to look at our actively managed portfolios, I would say a couple years ago we had significant overweight’s to energy. And I think now we’re beginning to trade out of it a little bit, not necessarily because we think that the oil price is going down, but because the stocks are what we think of as fairly value and there could be better value opportunities elsewhere.
But in terms of the Middle East, I was very interested to see that when news of the violence first came out, oil spiked up a little bit and then it’s began to trail off. And I think that’s an indication that the markets expect that the violence will be contained. And as long as the violence is contained, it’s unlikely to have a big impact on oil. And we’re also in a different place with oil these days. All of the fracking technology has made the US a lot more energy independent than we used to be. And so I think there’s a lot of sentiment around that as well. I mean, you ask about what’s changed, what’s not changed. Definitely the energy independence of the United States has changed today versus 30 years ago.
Meb:
Talking about energy. One of the things we like to look at and we try to tell investors, we say it’s important we think to be asset class agnostic and just to me it applies to sectors and really anything, it’s hard not to get emotionally attached to the investments we have. And certainly over time, it’s easy to get all hot and bothered about what happens to be going up. And one of the sectors… The two that really probably resonate almost more on the headlines or tech of course, and energy, and if you look at the sector composition as a percentage of the S&P, and I imagine it’s a little more stable with RAFI, but energy and tech have swapped places many times over the past 30 years. Energy at one point I think was 30% of the S&P and it bottomed the last few years, it’s somewhere around two or three, and I think it’s only up to about four. And that’s despite the earnings being about 11% of the S&P in tech as the flip side of that, right? The market cap is 30% and the earnings are less than 20. Is that something you find our sectors more stable with RAFI throughout time?
Que:
Definitely they’re more stable through time, mainly because the metrics that we use move very slowly, right? Sales, cashflow, dividends, they change year to year, but it’s not as if there’s an entire sector that will double its sales while some other sector halves its sales, right? The way you might actually see in the pricing world or market cap world. The other thing with RAFI is also that we look at these fundamentals, but we also take an average over five years to eliminate cyclicality because when you get energy, you get industrials, you may go through these cycles of peaks and lows and you don’t necessarily want to just be reflecting that. You want to reflect something that is stable over time.
Meb:
Yeah, I feel like that’s always a balance that we struggle with and talk about in our own shop is what is the sort of look back period, and you want to certainly take into account more recent information, but a lot of it happens to end up being noise too. And I think having, particularly when further you zoom out on assets, the longer periods to me seem to be more thoughtful on blending them. Any other areas of macro that we didn’t touch on that you think is particularly front of mind for you or your colleagues?
Que:
One of the things that I would say is that I think the dollar is an interesting question, right? Do we continue to see dollar strength or do we not? One of the things that we’ve seen is basically a decade of dollar strain, and so when does that come to an end? And everybody’s been waiting for the interest rate cycle to turn, but I do think that the conflict, the geopolitical conflicts that we’re seeing lends a little bit of further strength to the dollar, right? Just because of the safety that people are seeking.
Meb:
Yeah, currencies are always tough for everyone thinking in terms of currencies, most Americans really only think about them in terms of travel, but over time they can certainly move a lot in short time and on a real basis after inflation tend to be more stable than most think. You guys have this awesome module, and I haven’t logged in on a while. I need to check it back out, but listeners, RAFI has a great asset allocation interactive, is that the name of it, if I recall?
Que:
That’s right.
Meb:
But you can spend an entire day digging around on ideas and asset classes and projections and all sorts of good stuff in there. It has currencies too, doesn’t it? Do I recall correctly?
Que:
It has some currencies, but I think most people use it really for the asset classes because as you say, people don’t think about currencies unless they’re taking a vacation.
Meb:
Yeah. And they’re not thinking about [inaudible 00:27:44] asset classes. Now you can get 5%, the T-bills and Chill sort of portfolio allocation has been one that’s been cropping up more and more as people say. And it’s like a bunch of right retirees that won the income lottery. All of a sudden it’s ignoring the fact that bonds are down a ton, but the fact that you can now get income that you used to not be able to, I feel like is something that psychologically hasn’t been around for a long time. You mentioned something early that I think most investors would not agree with, for better or for worse, I have a long Twitter thread called, “Things I believe in that 75% of my professional peers do not.” And one that you mentioned was the Fed has done a good job, and I think a lot of… I mean, just from the media, I mean, media loves to bash the Fed. That’s the easiest target because it’s kind of unverifiable that the alternate outcome on what people could complain about. But we can talk a little bit about that, or you can say, “Hey, what are some beliefs you have that the vast majority of your peers do not share?” Something that you’d say, “Hey, this is what I believe.” And most people sitting around the coffee or dinner table would say, “Oh, my gosh, what are you talking about?”
Que:
I wouldn’t say that there’s a lot that I believe in that’s controversial, but then I would hold that opinion, right? Because I believe them. So I don’t think that they’re outlandish. Alan Greenspan was sort of the pinnacle of Fed Trust, right? He was sort of a rockstar, and in some ways that wasn’t necessarily good, right? The Fed should be doing its job behind the scenes. If they’re doing its job, you shouldn’t notice what’s going on. But the fact that Alan Greenspan became a rockstar, sort of invited scrutiny on the Fed. And then in the aftermath of that, we had the great financial crisis and the great financial crisis caused a whole bunch of dislocation. But one of the things that caused… But I would characterize as a tension in terms of the fabric of our society, right? Where it’s like the 1%… We can forget about this, but there was Occupy Wall Street, the One Percenters and so on and so forth, and who was getting what, right? What mortgages were being fixed, what car payments were getting canceled? Student loan forgiveness, all of these issues really came to the fore.
And during that time, I do think that the scrutiny on the Fed became a lot more politicized. People started talking about how quantitative easing was giving money away, but the reality is that we live in democratic society. And in democratic society, what do people care about? They care about jobs. And so if you’re the Fed, you have a dual mandate of employment and inflation and inflation is not a problem, but jobs are a problem. Of course, you’re going to have to keep the money flowing because that is your job. And some people were arguing in the teeth of the financial crisis was that the Fed should just sort of let everything contract and then rebound, but that’s really not their mandate. Their mandate is employment and inflation. And in the great financial crisis aftermath, inflation was absent. So yes, you had to go for the employment, and they did that.
I think that what’s happening now, is that they find that a little bit harder to balance, right? The other thing that they had to worry about, which was inflation has now come back. And so now what they’re trying to do is they’re trying to balance the inflation side and the employment side, and I think they’re doing a good job because yes, inflation is still too high for comfort, but at the same time, they’re not killing the job market. And I don’t know if we’re going to get a soft landing. I never thought we would be here. I thought that we would be in the middle of a recession already. But the fact that the labor market is still strong, the economy is still resilient, shows that they’ve actually navigated this reasonably well while bringing inflation down from eight to 4%. What happens in the future and the resolve of getting it back down to 2% or two point a half percent, I think is going to be a lot harder.
But so far, they’ve done a good job in getting us here. They’ve done it in the midst of a very difficult cycle. And the other thing about the Fed is that you forget that they’re not the only game in town, right? There’s also the fiscal side. So the one thing that they’re also fighting in terms of inflation is this fiscal expansion. So you look globally, everybody is still in fiscal expansion. You can’t have a situation where you have massive fiscal expansion and you expect the Fed to do it all in terms of bringing inflation down, right? And the fiscal expansion was really there because of COVID. Because it was necessary. But now that we’re past that, the Fed is doing its job, maybe we should be looking at governments and saying, what’s going on with the fiscal side to really get the house in order?
Meb:
As we kind of get closer to the year-end, 2023, what’s on your brain? Are you working on anything new? Anything got you particularly excited or confused or anything that is on your mind?
Que:
I think there are a couple of things on my mind. The first is always not necessarily value investing, but non-market cap investing. What does the future hold for that and where are the opportunities there? But that’s always something we think about at Research Affiliates. But I think the other thing that’s on my mind, and I think something that I’m very excited about is how to really evaluate quality, right? And there’s a lot of… One of the things we’ve always written about is that quality means different things to different people. But one of my colleagues has been doing some work using natural language processing to comb through 10Ks, 10Qs, and eventually we’re going to look at earnings calls to really identify what we consider to be high quality stocks. And so far, the findings that we have are very promising. So that’s something that I’m particularly excited about, and I do think that value is very cheap. Value is very, very cheap right now, but if you are to be involved in value, you also need to be very careful. And what you want is you want the highest quality stocks among the value universe. And so this is something that I think is going to be an important route for us going forward.
Meb:
You mentioned quality means a lot of things. How do you guys think about it? What is the main metrics for quality that you think are most applicable to how people should think about it?
Que:
Well, we have found to be sustainable is what I would call capital discipline. So looking for companies that invest their capital wisely and that return the capital or their profits to shareholder and don’t overinvest. So capital discipline I think is a very important, very durable thesis, probably the most important one of all. And then the other one is low distress. And here, that’s more important if you’re a value investor than if you’re a growth investor, right? If you’re a growth investor, you don’t look at a lot of companies that might be in distress. If you’re a value investor, you’re looking at these cheap companies and you have to sort out which ones are just dislocated in terms of their stock price and which ones are structurally challenged and they’re going to go out of business, and you want to avoid those. And so you’re constantly having to screen out stocks that have high distress, so you want to evaluate the ones that have low distress.
Now, having said that, I think that these are things where they’re negative screens, right? You don’t necessarily want the company with the most conservative capital discipline because maybe they’re not investing enough in their business, maybe they’re not aggressive enough. You don’t necessarily want companies with unlevered balance sheets because maybe they… Again, they’re not pursuing growth heavily enough, but you do want to avoid the ones that are going to go out of business or the ones that waste money. So it’s really more of a negative screen than a positive screen per se. But the other thing that you also want, I think, is you want companies that… And this is where reading 10Ks and 10Qs becomes important that have a consistent business strategy over time. If you find companies that have constantly changing business strategies as revealed in their 10Ks and 10Qs, that can often signal some sort of instability in their business, challenging business conditions, companies that are just dealing with bad news quarter after quarter. So those are some of the things that we think are important.
Meb:
Well said. Always a struggle between trying to find the ones… The high quality and watching in awe as some of the low quality shoot to the moon in various periods is always tough to balance. When you look back on your career, and this could be personally or with work at some point, what’s been your most memorable investment? Could be good, could be bad, in between.
Que:
So my most memorable investment was actually… And I hate to say this because this is not how I would recommend investors, invest. Was a tactical opportunity in a special situation fund at Brevan Howard. And what we were seeing at the time, was a dislocation in the yield curve. And the yield curve, I would say at that time… This was pre-COVID. It was about… I want to say 2018, 2019. So what we saw was the yield curve was extremely flat and yield curves just don’t stay that flat for that long. So the yield curve will tend to steepen for two reasons, either because the Fed is cutting interest rates because you have a recession or growth comes back and the long end goes up, right? And at the time, interest rate volatility was extremely low, and so you could actually construct a steepener using options or exposure steepener using options in a very, very cheap way.
Now, what would happen is, it’s all a matter of timing, right? Because you’re paying out these premium and options and then you’re waiting for the event to happen. And so there was a trader at Brevan Howard that had an interesting thesis around that, and he put together a special situations’ portfolio, we invested in it, and a year later we basically doubled our money. Now, the reason that was memorable is because on the one hand, it’s nail-biting. You’re constantly paying out these premium, right? Month after month, you’re looking at negative returns. And it’s also exciting because when the event happens, you basically make a whole bunch… You make all of your money back and more in a short period of time. The reason I say that this is not how people should be investing, it’s not necessarily repeatable, right?
What you want is you don’t really want that much excitement in your portfolio or the majority of your portfolio. Maybe a portion of your portfolio you can do things like that with, but the vast majority of your portfolio, you want things that go up over time in a reasonably reliable fashion. Things like stocks, right? Yes, you may have a year where it goes down 20%, but the following year it tends to go back up and you accumulate that wealth over time and it’s repeatable, right? Earnings are repeatable, interest payments are repeatable. Special situation trades are not necessarily repeatable, but they’re exciting and fun to talk about.
Meb:
Well, we have had and continue to have a funky yield curve today, so maybe there’s time for another yield curve trade in your arsenal. I don’t know. We’ll see how this plays out.
Que:
Yeah. But you know what? The problem is that volatility is not as cheap as it was. I mean, pre-COVID in the 2017, 2018, 2019 period, volatility was so cheap. They were basically giving options away for free.
Meb:
Yeah. That happens on occasion. I remember that, but I also used to laugh because people would still go on TV and say, these uncertain volatile markets. And I say, “Well, what are you watching?” Because these are the least volatile markets I’ve ever seen. You can’t just say that when at any point just to say the future’s uncertain, which is always true. Que, where can people find you? If they want to keep up with your research, what you’re up to, what you’re writing about, what’s the best place?
Que:
Research Affiliates website, ralc.com or researchaffiliates.com, will get you there.
Meb:
Awesome. Que, thanks so much for joining us today.
Que:
Thank you for your time.
Meb:
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