Robert Arnott on Global Asset Management (Podcast)

fascinating research pieces, hence the name Research Affiliates. That you know, after you read the third or fourth thing from somebody in a couple of months, it's like, damn, I gotta get robbed back on. This is some really interesting things. We went deep into the woods on electric vehicles in Tesla and we talked about what makes a big market delusion when an entire sector, not just a company, a whole sector runs amuck. We talked about everything really, from

E s G to bitcoin to value. I thought it was really intriguing if you're at all interested in fundamental indexing or smart beta, if you're interested in where alpha comes from and what the sources of various value and other types of factor premiums are, then you're going to find this to be absolutely fascinating. So, with no further ado, my conversation with Research Affiliates Rob are Not. This is mesters in Business with very renaults on Bluebird Radio. My

special guest this week is Rob are Not. He is the founder and chairman of Research Affiliates, a firm that has created and patented a methodology for creating indexes based on fundamental metrics instead of the traditional market cap waiting. Various asset managers are unning over a hundred and sixty billion dollars using strategies developed by Research Affiliates. Rob is the author of over a hundred academic papers, seven of

which one Graham and Dodge Scrolls and Awards. He is the co author of the book The Fundamental Index A Better Way to Invest. Rob are Not, welcome to Bloomberg. Thank you so much. It's a privilege. Well, it's pleasure to have you back. There's so much to go over since the last time we had you on the show about three years ago. Let's just start out with Research

Affiliates or or Raphaels as I know it. Um, you guys don't manage assets directly, but advise on over a hundred and sixty billion dollars in assets, explained to the listeners how that process works well. We want to focus on our area of competitive advantage, and that is in doing research and develop investment strategies, in carrying out um UH and exploring potentially disruptive ideas for the investment management community.

UM to run an asset management firm also typically means UM call center, means portfolio accounting, it means UM trading desk, trade reconciliation departments, and the list goes on and on and on. So the last time I ran an asset management firm first quadrant back in two thousand four, we had about twenty people and a roughly twelve were in research. Here we've got about eighty people and roughly half of

them are in research. So we're able to concentrate our attention on our area of competitive advantage while at the same time using affiliates external distribution partners to handle distribution and quiet relationships. And so basically they view us as an extension of their R and D capabilities. UH. Certainly, they're not going to replace their R and D efforts, but if our ideas are complementary, then we're an extension of that and we view them as our distribution channel.

Let's talk about one of the strongest research ideas and strategies that you and your farm are behind. And and that's the basic concept that hey, we're doing this index waiting thing all wrong. Instead of doing it based on market cap or the size of the company, it's instead it should be based on fundamental metrics like revenues or profits. Explain why that's a better approach. Thank you for asking that.

A lot of the attention in the world of so called smart beta is on formula based techniques for investing, and the umbrella terms smart beta began as a focus on strategies that no longer weight companies in direct proportion to their price, which is what cap Waiting does, and

it's cap Waiting's heel Achilles heel um uh. If you wait companies in proportion to the their price, than any company that's above its eventual fair value and destined to underperform will have a current weight that's too high, and any company that's cheap and destined to outperform will have a current weight in the portfolio that's too low. So you're gonna be overweight the overvalued and underweight the undervalue even though you don't know which ones are which, which

is an interesting nuance UM. But the term smart beta has since been broadened to embrace factor investing, and basically anything that uses a formula, even momentum investing, is called smart beta, although it's the antithesis of the original definition. UH Fundamental Index was an idea that we came up within two thousand three in the aftermath of the bursting

of the tech bubble. A dear friend of mine who was on the board of the New York State Pension and was founding president of Common Fund, which manages commit Um university endowments. He was horrified at the amount of money that was lost by major pension funds by investing in cap weighted indexes. As the tech bubble burst. Four percent of the portfolio UM invested UH in the largest market cap company at the time UM Cisco, and Cisco

subsequently went down. Something like so there went if you had four percent in it, there went three point six percent of your money and one single stock, okay, UH. He challenged us to think about better ways to invest, and we came up with the idea, an idea I had been playing around with for a few years. Why on earth do you want to invest in proportion to market capitalization, which means that the more expensive the company is,

the more heaviest weight in the portfolio. Why not wait companies in accordance with sales, or with profits, or with book value, or or even with a number of employees. So UM, we went back and tested the idea first, starting with sales and book value and going back thirty plus years. We found that if you chose the thousand largest businesses in the US based on their sales and wasted them by their sales, that you wound up two and a half percent a year better off than with

cap weighted indexing. And we tested it with book value, We tested it with offits, with cash flow, with EBA, duh, with number of employees. UM, and everything we tested had one and a half to two and a half percent access return. So that was our first a ha moment that oh, it doesn't matter what measure you're using. What matters is whether the measure incorporates price, because if the price is too high, then any any waiting scheme will

do better. You could use darts, or you could base it on the number of executives who like to have a mustache or whatever. Um and you're still breaking the link with price, and you're still going to add one and a half to two and a half percent a year. Cool. And so we developed the idea of Fundamental Index, which has become a very important part of our business. It's over a hundred forty billion in assets now and it's under licensed to other distribution partners Pimco, Schwab, investc Amura,

and the list goes on and on. We have at least eight part distribution partners with at least ten billion each managed using our ideas. So what is cool about Fundamental Index is that you're earning a profit based on two things. First, the obvious one a value tilt. If growth stock is priced at lofty multiples to fundamentals, then you're rewaiting those stocks down to their economic footprint, the size of the business. And if a stock is trading

at deep discounts, you're rewaiting it up. So you have a stark value tilt all the time, and value investing usually wins. But it turns out that's not the dominant source of incremental return. It turns out that the dominant source of access return is a rebalancing discipline. If a stock soars and the fundamentals don't, then RAFI. The fundamental index will say, thank you for those lovely games. Let's

rewait this investment down to its economic footprint. And if it's company tumbles and its fundamentals don't, rathey will say, oh, thanks for the lovely discount. Let's rewait you back up to your economic footprint. So, since the market is constantly changing its mind as to how much a company is worth, you're constantly rebalancing contratrating against the market's most extravagant bets, and your biggest bets will be on the companies where

the market is making the biggest bet. In the opposite direction, the companies that have soared the most. Game Stop swared tremendously this quarter on top of an already stupendous rise in two thousand twenty. So you'd look at that and say, if you owned it, which we did, we owned it as a value investment with a cost bay syst of around a little under four bucks share. If you owned it, you'd say, thanks for this great gain. The underlying fundamentals

haven't changed. Let's take some profits and rebalance that rebalancing alpha is the dominant engine for incremental return, and that is not true of most of the strategies that currently carry the smart beta label. That's interesting that the pushback I've heard from the traditional market cap weighted index ers are on the on the one hand, you're selling stocks that have rallied and very well may continue to rally.

If if you're rebalancing away from Amazon or Apple anytime over the past I don't know, twelve years, you know you saw the stock go higher. And on the other hands, on the cheap ends, you have a tendency to buy into the value traps, things that look cheap because they're in a spensive and still have revenues but aren't. What's the counter to that critique? That critique is absolutely correct.

M Here's the deal, though, for every Amazon, there is UM, a company that is perceived as a disruptor that subsequently gets disrupted UM. Apple has been hugely successful in contratrating out of Apple has not been a good thing. But who came before Apple? UM? BlackBerry Palm. Palm was dominating the world of handheld communication devices back in the year two thousand when it was spun off from three com it's spun off at evaluation briefly greater than General Motors

at the time of the spinoff. It was spun off from three com at a total market value larger than three comes market value before of the spinoff. Isn't that interesting? And um, of course it went to zero and BlackBerry disrupted Palms business. And then no sooner was BlackBerry dominance and world straddling on handheld communication devices than Apple came along with the iPhone and said hey, hey, this is a whole lot better, and so did the marketplace. So

disruptors do get disrupted. And yes, we missed the boat on highly successful companies that go from strength to strength to strength until they don't. And on the down side, you do have value traps, you'll rebalance into them in theory all the way to zero, which is one reason you absolutely do not want to rebalance a fundamental index strategy daily, because then you'll just buy into the value traps all the way to zero. So there's two broad

flavors of fundamental index. One rebalances annually, the other does what's called quarterly staggered rebalancing, which means every quarter you move one fourth of the way to your target weight. That way, you're going to be hurt by value traps only modestly, only occasionally. And for every value trap there are several companies that look cheap and in fact are so case in point two thousand nine trough of the financial crisis that the March two thousand nine rebalancing that

took place in Fundamental Index um UH. We rebalanced to the economic footprint of businesses b of A and City. We're both um priced at a fraction of a percent of the market, and yet both of them were about two of the US economy measured in terms of of revenues, profits, book value, dividends and so forth. General Motors was about one percent of the economy and a tenth percent of

the market. So we rebalanced into all three. We rebalanced back up to a one percent WAIT and GM and two percent each for the A in City and GM went to zero. In the next quarter went bust value trap. There went one percent of our portfolio. The two percent each in the of A in City tripled, so you wound up going from two to six in two stocks

and from one to zero in a third stock. So the beauty of Fundamental Index is not that it has any special insights into what the fair value of a company is, but that it contra trades against the market's most extravagant bets, which often in the long run turn out to be wrong. People love to buy growth stocks because they've got a great, great story, But the right question to ask is not is this company a great company? If it's a growth stock, of course it's a great company.

The question is how much good news is there in the future for this business that isn't already in the consensus opinion and already in the current price. Is there more likely to be downside surprise growth that is less extravagant than expected um, or upside surprise where lofty expectations

are actually exceeded. Amazon is a beautiful example of a case where lofty expectations have been exceeded again and again and again, and at some point they won't be But who knows when it's a brilliantly run company with a brilliant product that is disrupting vast squaws of industry um. Kudos to Bezos and his team, But the price of the stock reflects an expectation that the growth of the last decade will persist in the next decade and that's

a little dangerous. So you guys actually received a patent for this methodology of selecting securities and creating indexes. Um. Why a patent? What does that do for the firm? It's really kind of fascinating to see a financial methodology actually awarded a patent. Well, method patents are not new. They've been around for decades. UM. Uh early days of patents, it had to be something you could hold in your hand to be patented. UM. But over time, with the

advent of computers and so forth. UM, the notion of method patents applied to UH, software methods, computer software methods, UH, even business methods if they were truly unique, truly different, and truly disruptive to an industry. Um, why shouldn't it be patent to Now? The issue that I think bears mentioned is we could be in the business of product innovation or in the business of patent litigation. UH which

expertise do we have? The former not the latter. So I view the patents really as a stake in the ground to say to the financial services community, Hey, this is our idea, please respect it. Please UM license from us at modest fees if you want to use this idea, work around the patent if you want to explore something similar but different. Competition is a great thing, UM, And what we've found is the financial services community as a whole lot more um, honest, and has more integrity than

its reputation. A few bad eggs in the financial services community tarnish the reputation of the whole community. So what we found is that there have been a handful of cases where somebody just took the idea and ran with it, and the vast majority of folks in the financial services community, if they liked the idea, they'll come to us and say we'd like to license it. And if they don't like the idea, they don't have to use it. So the patent is not so much a basis for going

after people. It is a basis for saying, hey, please respect our space. Speaking for credit for respecting intellectual property. For a long time, I've heard you credited with creating the phrase smart data, UM, but you've described that as more something you've popularized and created. Give us a quick explanation of that. Sure, there's a consulting firm that works with some of the largest pension funds in the world

called Towers Watson their London an office. UM coined the expression smart beta, and the idea was not that cap weighted index funds were stupid beta. The idea was that, um, the cap weighted index funds were a neutral form of beta. They called it bulk beta um UM. And the stupid beta is those who chase fads and load up just

on whatever's gone up the most. And the phrase smart beta was attached initially just as strategies that broke the link with price, that would trim a stock if it's price went up and all else remained unchanged UM and so that included equal weighting equal waiting. Is about as simple as strategy as you can imagine. How could it be smart? Well, it's smart because it has embedded rebalancing, although it does have a profound small cap tilt that

makes it less liquid and more expensive to trade. Fundamental index was the inspiration for the term smart beta, but I never invented the term. I liked it. I thought that's a clever way to label it. And then pretty soon everybody under the sun was saying, oh, we do smart beta. You had index calculators saying, hey, our growth and value indexes are both smart beta. No, they're both tied to the price of the stock. They're still cap weighted. Um.

You had factor investors saying our value factor is smart beta. Well, that's true because it does contratrade. Our momentum factor is smart beta. No, that chases whatever has gone up the most. Our quality factor is smart data. No, that's going to load up on whatever is expensive. Also, so you had lots of organizations embrace the phrase because the phrase itself sells. It helps selling product. So I like the expression smart data,

but I like its original definition. And if smart beta is applied to everything under the sun, smart ideas and stupid ideas, then the term ceases to mean anything. And I think that's where we are now. Rob you wrote a really fascinating peace with your team titled Big Market Delusions Electric Vehicles. I want to start with your definition of quote big market delusion. That's when all the firms in an evolving industry rise together even though their competitors,

and ultimately some will win and some will lose. Why does it not make sense for investors to just own all of the basket of everybody in that space and eventually the market will self correct. The winners and the all outweigh the losers. Well, that is the basic definition of diversification. And it makes sense unless all of the firms in the industry are priced as if they will

be outlier winners, because they won't. Um If if a company is priced as if it will achieve stupendous success, and it achieves its stupendous success, wonderful you did find you didn't get hurt by that. If five companies are all priced as if they're going to be stupendous successes and you know that only one or two of them will, then you've just bought a basket that collectively is destined

to perform badly. The guy who coined the term big market delusion is Brad Cornell, past professor at U C l A and at cal Tech, and uh, it's an idea that's been around, but it's a great term to capture the concept. Back at the peak of the tech bubble, there were several of us, me Cliff Fastness, and probably dozens of others who pointed out that not all the tech companies will win, and they're all priced as if they will all win, so as a segment, they were

collectively extravagantly overpriced. You can even have it on the other side and anti bubble like at the trough of the financial crisis, financial services companies were all priced based on the perceived risk of bankruptcy, and so they were priced as a call option on future survival. And yet with each company that failed that went out of business, the landscape was now cleared for the others to earn outsize profits in the subsequent economic rebounds. So big market

delusion can play out in both directions. We singled out electric vehicles because at their peak during this last quarter, Tesla was priced at thirty four times its annual run rate sales UM. Now there's eight companies around the world that specialized in electric vehicles. Tesla was the second cheapest of the eight in terms of measured market value to prior year revenues. Thirty four times sales was second cheapest

on the list. The others were ranged from uh The others ranged from about twenty times sales to literally ten thousand times sales. So when you have those kinds of valuations, the winners might might be worth their valuations, but the losers most assuredly won't. And that's the nature of big market delusion. I have no idea if Tesla will be worth its current price. I very much doubt it. But I have absolute confidence that the collective e V market

is not worth its current price. Well, I know they've had offense pastic run ending um the in the research piece, you use January thirty one of this year to show how far all of these companies have have come. Um, are they remotely like? I'm thinking of the old days of biotech, where it was impossible to come up with evaluation because it was so binary. You would end up with, Hey, either this company develops a molecule that does what it's supposed to and then becomes a stupendent success, or it

doesn't and it's a zero. Or should we be looking at these e V companies the same way. Either they're gonna put out a successful car and that's what jump starts them, or they're just expensive R and D shops for now and perhaps might be worth nothing. Well, the correct way to do the kind of analysis you're talking about is, if this company produces a disruptive product that massively changes the industry, what's it going to be worth and what are the odds that this will happen with

this company as the dominant winner. The missing piece in a market. Big market delusion is that latter piece. If all of them are priced as if they have the potential to be massive successes, then you have a problem. And that's that's the issue we're dealing with Tesla. Is it is its current valuation too high or is it in bubble territory. One of the things that I think is interesting is everyone band these around the word bubble as if it has some clear meaning, and it doesn't.

Usually it's used in retrospect after a bubble has burst. So we came up with a definition back in two thousand eighteen we that we think can be used in real time. And that definition is very simple. Um, if you're using a discounted cash flow model, you would have to make implausible assumptions about future growth to justify the current price. And second part of the definition just as important, Um, the marginal buyer has no interest in valuation models. Let's

take Tesla as an example. We UH did a piece on Tesla last December as it was on its way into the SMP, and we had done an analysis where we assumed, let's let's say Tesla's book of business at sales grow fifty percent a year for the next ten years. Now, how plausible is that. Well, Amazon, the big winner of the two thousand tens, grew six percent a year over the decade ended two thousand twenty a year. That's enough to make a company eleven times as large in just

ten years. Fifty sent a year makes a company fifty five times as large. So tacitly, we were assuming that Tesla would be five times as successful as Amazon over the coming decade versus Amazon over the last decade. All right, that's a pretty darned extravagant assumption. We then said, let's us further assume that Tesla is has a an after tax profit margin ten years from now. That is, that matches the highest after tax profit margin of any automaker

in the world in the last decade. Well, there was one year when Toyota hit a ten after tax profit margin. So let's assume gross profit margin. Um well, that's pretty good profits. If you discounted that back to current prices, you could justify a price of fos tequ was twice that. So that's an example of um uh using a definition of bubble to test it in real time. Now, con Tesla wind up using other markets to justify the current price. Perhaps,

but you're really dealing with some pretty extravagant assumptions. And the point of big market delusion wasn't that Tesla is a bubble poised to crash. I do think Tesla is an extravagantly overpriced company that will investors will be very lucky to have positive return over the next ten to twenty years, very lucky indeed. But the point of big market delusion is um if you look at the electric vehicle industry in aggregate, it's worth about eight percent as

much as all other vehicle makers combined. And oh, by the way, over half of all electric vehicles are made by those other existing players who make conventional cars and electric cars. So the e V specialists comprise less than half of the EV market and have total valuation very nearly that of companies that collectively produced nearly a hundred times as many vehicles, a hundred times as many vehicles.

You know what's so fascinating about that is how, after really taking their time, the traditional internal combustion engine car manufacturers have really ramped up their e V game. I had Afford Mustang for a week. I got to play with really a very nice, very well made car, good looking, very high quality, surprisingly high quality UM and in many ways way superior to not the software of Tesla, just

the physical vehicle. The new Volkswagen I D four is getting really good reviews were and that's before we start talking about what's coming out of Mercedes and an Audi. Audi has a run of um RS cars that are very competitive, the same with the Porsche take in turbo as fast as cars that cost ten times as much. So I know the e V manufacturers are all battling amongst themselves, but there's a really strong case to be made that the future of electric vehicles is coming from

the internal combustion group. I think that's exactly right UM when Volkswagen our Toyota decide, well, Toyota has been a pioneer UM in hybrid technology, which by definition means they've been a pioneer in electric vehicle technology UM for longer than Tesla has been in existence. So nobody's gonna deny that Tesla has been a massive disruptor, that Tesla has a big head start, and that Tesla has a surprisingly

good product for a newbie automaker. But when Toyota decides to spend more on electric vehicle um uh innovation, then Tesla could plausibly take in as gross revenues over the coming three to five years and to do that every year. Um okay, Tesla is going to have some serious competition.

So um. The whole notion of big market delusion is that people look at disruptors and say, these disruptors have the future in their sights, they know what's coming, their position for it beautifully, and they overlook the fact that disruptors get disrupted. It happens again and again and again. There's no doubt Tesla has a lead in things like over the air updates and autonomous driving and the supercharging network.

But you already see companies like Lucid, which their new vehicle, the Air is coming out later this year, much longer range, much smaller electric motor. It's a midsize car on the outside, and the inside it's a full sized vehicle. Because they were able to miniaturize so many components. They really brought um a lot of impressive technology to the game, disrupting the disruptors. What does history tell us that's like? So you mentioned phones. What about other things like PCs or

televisions or railroads? Is that historically consistent? The disruptive technologies themselves eventually gets disrupted. Oh, that happens again and again in industry after industry. It's hard to It's hard to come up with any industry where the disruptors weren't ultimately displaced by new disruptors. I mean, how many search engines did Google displace UM in its rise to to dominance of the search engine space? I read one study that said there were twenty six search engines that came and

went with Google as the ultimate survivor. Will somebody disrupt Google? Who knows? UM? Is it priced to allow for the possibility that a disruptor will knock them from their perch. No, it's priced for the um expectation that that can't possibly happen, and and it could happen. UM. This is this is the achilles heel of growth and momentum investing that UH

disruptors do get disrupted. I recall a couple of years ago you had done a study about the additions and deletions to various indexes, And it turns out, especially with the SMP five hundred. The companies that get added underperformed the companies they replace, and in Tesla's case, that would be Apartment Investment and Management. Uh, you guys are forecasting that this is going to outperform Tesla over the next one, five, ten years. What what do those numbers look like historically

for additions and deletions. Well, just to be clear, we aren't forecasting that um uh that uh Tesla will underperform a I VUM by two thousand basis points. Were observing that historically that's been the norm, and so that's a little bit different. But um, the norm is that the companies that are added to the S and P five hundred underperformed by about two in the subsequent twelve months

after they're added. Companies that are added and are already in the top one hundred by the time they're added underperformed by about seven over the coming year. Now, no company other than Tesla has ever been added which ranked in the top ten the day it was added. Um, and so one would assume, extrapolating from history, that its performance in the first year would be expected to be negative to an extent that's larger than those historic norms.

The Companies that are dropped, on the other hand, usually are small, thinly traded, ill liquid, and they just get clawbered as they get removed. But they're underlying fundamentals usually are mediocre. That's why they're dropped, fully reflected in the price before they're dropped, and bludging down to unreasonable levels on the way out. And the result is the companies that are dropped from the SMP UH. And here we're excluding corporate actions. A company that's dropped from the SMP

because it doesn't exist anymore doesn't count. But discretionary deletions like apartment investment in Management on average historically beat the SMP by over two thousand basis points UH in the first year after they're deleted. So that would suggest to us that based on history, Apartment Investment and Management would be expected to beat Tesla by maybe thirty percentage points

in the first year after the change was made. Tesla's kind of a special case because everyone knew that SMP was going to have to add Tesla, and the Investment Committee of SMP just basically said, hey, we've got a rule. If you don't have profits for the last four quarters,

we're not going to add you. And so in March of two thousand and twenty, I remember seeing speculation in the media that if the first quarter was profitable, Tesla would finally have four consecutive positive quarters UM and the S and P would have no choice but to add them, and that set Tesla off on a on a tear.

So Tesla was up I think the number was six or seven hundred from its March lows until the decision was announced in November to add them uh and then up another or more from the announcement date to the actual inclusion in the index. Just astounding numbers because Tesla was a big company, big market cap company, and so the addition to the SMP meant that the market the index funds would have to buy upwards of two hundred billion dollars worth of the stock on that same day.

And of course it's not that anyone didn't anticipate that hedge funds would load up on it in anticipation of flipping it to the index funds, and of course they did. UM. So additions and deletions to indexes have their own special characteristics and are very much disrupted. Continue to be amazed that academia hues to the notion that markets are efficient. Has anyone thought to put a long short fund together of these additions and deletions. It sounds like that's a

potential alpha generator. I think it's a potential alpha generator. It's going to be a very niche oriented strategy because let's say there's let's say there's twenty changes in the index in a given year, You're gonna go long twenty very illiquid stocks just before they're dropped UM and short twenty very liquid, very popular stocks, uh, just as they

get at it. So you're gonna wind up UM having a big short on large cap stocks and a big long on small cap stocks, a big short on growth stocks, a big long on value stocks, and a big short on highly liquid stocks, and big long on highly illiquid stocks in a lumpy, concentrated portfolio. So I think as part of a broad strategy it would be a fun thing to put together. As a standalone strategy, I think it would have a little too much risk for the tastes of most investors, to say the least. So let's

talk a little bit about value. You wrote an interesting piece with your team titled Reports of Values. Death may be greatly exaggerated tell us about why value ain't dead yet. Well, whenever anything in the finance world is called dead, chances are it's it's about to come back to life. However, I would say that we've been hearing reports of values death for three or four years now, and so it sure took a long time to begin its recovery. UM.

The narrative is growth stocks are better. Growth have better growth and better profit margins than they used to. Value stocks are more disrupted, and disruptors are getting better and faster at disrupting and just demolishing vast slaws of business UM, and so values really had its day and is not coming back. Well, why would value fail again? The narrative fills in the details. One of the core engines for

the value factor is migration. A company that's in the growth segment falls out of favor, tumbles invaluation multiples, pulling down the performance of the growth portfolio, and then it's kicked out and replaced with a new high flyer. UM. A company is um on the values side turns out not to be facing as severe headwinds as people feared, so it's valuation multiple sore, and then it's replaced with

a new, deeply unloved value company. So you get this constant rotation for growth, underperforming out for value, outperform, and out, and that's the dominant engine for the value factor. It's largely offset but not entirely offset by the main profit engine for growth, which is the companies are growing faster, they're more profitable, they're better companies. Of course they are.

That's why they have the higher multiples. And so if in an efficient market, the benefit of growth should pretty much exactly offset the benefits for value from its migration from its rotation. Now the narrative is um that that rotation is slowing and the difference in quality between growth and value stocks has widened. There's truth in that narrative. There's truth and most narratives. The migration has been slowing, but not by much. The differential in profit margins for

growth versus value has widened, but not by much. And so one of the shocking findings was that during the worst period for value investing in history, a period of time when if you're using price to book to define value, value underperformed growth by fifty nine percentage points over a thirteen year span, just horrific underperformance. How much of that came from value falling out of favor and becoming cheaper

relative to growth. Well, it turns out well over the under performance was value getting cheaper, not value companies under performing. So what we found was that the relative cheapness of value went from being one fourth as expensive as value as growth to one twelfth is expensive in that thirteen

year span. That means that value cheapness fell by sixty seven percent while its performance fell by Okay, that sounds like a subtle nuance, but what it means is that if the relative valuation hadn't moved, value would have beak growth again in the last thirteen years and again in the last three years during the really dreadful meltdown for value.

If you've got a stock that has fallen by sixty or fifty or six, but it's pe ratio has fallen by sixty or sevent do you look at that and say, get me out of here, I can't stand the pain. Or do you look at that and say, I can't believe it's this cheap, Let me buy it. I leaned towards the latter interpretation. Now, the second nuance in the paper that I think is very important is that price to book is the worst measure for defining value. If you use price earnings ratios, the peak wasn't back in

two thousand seven. The peak was in two thousand fourteen. If you use price to sales, it was two thousand seventeen. If you use fundamental index to cap weight our strategy, it was two thousand seventeen. It makes a big difference between whether you've got a thirteen and a half year dry spell where values underperforming and a three and a half year dry spell. The former is really hard to

stay the course. The latter is less. So so I look at UH price to book as a terrible measure, and we, in fact, in that same paper dive into that and show that price to book that book value itself misses all the intangibles we've heard. We've all heard the cliche that our assets go up and down in the elevator every day. Well, that is true of bigger and bigger swaws of the US economy or the world economy.

Then used to be the case. So we found that intangibles, Uh, we're about as large as tangible book value fifty years ago, and now it's as large. Means book value would double, literally double, if you include intangibles. We also did a test and found that if you use price to book value where you adjust the book value for intangibles, Firstly, the performance of the price to book value factor is twice as good over that last fifty seven years as

it was without um adjusting for intangibles UM. And again the peak was two thousand and fourteen, not two thousand seven. So it works much better if you take account of intangibles. But price to book is not the only measure. It's not even by a long shot, the best measure, huh

and Rob. When we're talking about things like intangibles, we're referring to things like patents, copyrights, processes, methodologies, things that just don't show up in the traditional Hey, here's our factories, here's our headquarters, those sort of measures of book value. That's exactly right, quite interesting. So for value to start generatinging that value premium again, what has to happen? Do we need to see mean reversion against growth? Do rates have to tick up, or do we need to see

a recession? What's going to be the the thing that could kick off value reclaiming it's premium. Well, We've already had that recession last year, and it was a doozy um. The narrative was, and again, narratives are always based on some measure of fact. The problem with narratives and investing is that they move prices much too far. The narrative was that the growth companies are beautifully positioned for a

COVID world and a post COVID world. True. The narrative was, value stocks have much higher risk of bankruptcy, and in the face of the COVID crisis, especially the business lockdowns, is going to be sweeping bankruptcies. True. Now, what was overlooked was almost all of those bankruptcy we're in companies

that were too small to be publicly traded. So there were literally millions of companies that went out of business last year, but shockingly few of the thirty million businesses in the US, only thirty five hundred are publicly traded. And of those thirty five hundred, let's say twenty or value stocks, shockingly few went out of business as a consequence of the lockdowns. So all you needed was for people to realize ge uh, these value companies didn't fail.

Maybe I should now start pricing it not based on bankruptcy risk, but based on its likely future P and L, and all of a sudden, the turn happened at the beginning of September, just when people were starting to realize, hey, vaccines are about to be rolled out. Uh, this is looking promising as an end to the crisis. And a lot of these value companies are just not going to go bust, so maybe I should reprice them for their

future success. And we've seen that in in energy stocks and cyclicals, in bank stocks that rotation away from growth, a lot of which were worked from home stocks and towards traditional economic early cycle recovery stocks. That seems to be really moving along unless I'm I'm seeing it wrong. What what are your thoughts on that? I think that's

exactly right. Um. We did a test looking at draw downs um when value underperformance growth, and it ranges from you know what, one month value underperforms growth by half a percent, so that's a half percent draw down from the last peak and thirteen years underperformance by fifty nine percentage points. We asked the question, historically, is there a link between the magnitude of the draw down and the

magnitude of values out performance? In the subsequent two years, and we found that when when value has underperformed by more than three thousand basis points, it has no examples historically of sailing to outperform over the next two years, with an average outcome between four and five thousand basis points about performance. So, when you see the nature of that particular relationship, extrapolating to the current size of the

draw down um uh. And extrapolating is always dangerous. But if past is prologue, and if extrapolating that relationship to today's unprecedented draw down works, then value would be expected to outperform growth by over one hundred percentage points over the next two years. You know, if it's a third of that, I'll be thrilled, to say the very least. Let's talk a little it about yields and inflation. We've been hearing a lot of chatter about yield starting to

tick up higher from admittedly low historical levels. Does this have any meaning for value, stocks or the market as a whole? What what should we take away about rising yields? Well, firstly, it bears mentioned that yields are not well correlated with the stock market. The stock market um has stocks and bonds tend to have a negative correlation except during inflationary times when inflation is rising or is materially elevated. And so what we find is that it's a poor linkage.

But but um, again, the narrative is low rates justify high valuation multiples and justify a bigger spread between orowth and value than historic norms because growth stocks are going to grow for a long time, and if you're discounting at a very low rate, that future growth is more valuable than it was at a high rate. Okay, it makes intuitive sense. Going back over long periods of time

in history, you still you find lots of anomalies. Okay, in the early fifties when interest rates were not too much above current levels, um, what was the average valuation multiple for the market, It was a third what it is today. What was the average spread between growth and value? It was a fraction of what it is today. So and when you look at um non US markets, European and Japanese markets in particular, where rates are zero, you find valuations are not as elevated as in the US.

If the rates are even lower, why not that the spread between growth and value is not as wide? As the U. If the rates are lower, why not. But a narrative can drive markets, and so the rising interest rates I think has a lot to do with the recent underperformance of fang stocks and the recent performance of value stocks. UH. Basically, the rumor that this might happen becomes a self fulfilling prophecy on a short term basis. On a long term basis, I don't think the linkage

is all that useful or interesting. And I assume the same goes for inflation and inflation expectations or or does that result in a different outcome that's a little bit different. Rising inflation UH clearly does horrible things for bonds and also UM increases investors risk aversion inequities, so when stocks

are expensive, rising inflation has a nasty impact. So the real question is UH, is the current increasing rate of inflation a temporary consequence of deflationary pressures twelve months ago and a snap back in pricing over the last twelve months, or is it a sustained consequence of UM Today's central bank and fiscal policies around the world which looked to all the world to me like a full wholehearted embrace

of modern monetary theory, So let me ask that question. Now, deficits, as far as the eye can see, it doesn't matter if it's a Democrat or Republican in the White House. Either it's tax cut and spend or tax I can spend. But we've seen nothing but deficits were my entire at out life with a couple of I think in or we had a balanced budget for a year or so. What is What is the rise of modern monetary theory mean for markets? Well, modern monetary theory is a little

bit like Caynesianism on steroids. Canes basically said, Hey, you can spend more money than you're taking in in taxes, and you need to during an economic downturn. Then you cut your deficit spending when the economy recovers because the money the spending isn't as needed and you can run a surplus to pay back the increase in the debt. Well, that's gone right out of the window. I think Canes

would be horrified at current economic theory and practice. Modern monetary theory takes it another step, basically saying, um, central bank can print whatever money the policy elite wants to spend, as long as that spending goes to increase employment and therefore to increase future revenues to pay this act. Um. Okay, as you said, it's it's um um not sensitive to

who's in the White House. Uh. I joked last year in the run up to the election, when people would ask about the election, I said, Look, we have an incredibly important choice ahead of us. We have a choice between somebody who will run two trillion dollar deficits as far as the eye can see in somebody who will run three trillion dollar deficits as far as the eye can see. I may have heard on the downside on that latter one, but to say any of the least. Yeah.

In any event, the usual immediate question was yes, but who is who, to which I would reply exactly. So let's both both parties have embraced MMT. Yeah, it certainly seems that way. Let's let's stick with the topic of recessions and recoveries. I am a big fan of Campbell Harvey, an academic who is now a part of the team at Research Affiliates. When when did Campbell Harvey join Raffie and what does he do? I'm a huge fan of

his work. Um, I'm a huge fan too. We we kept inviting him to join our advisory panel, which used to meet once a year UM, where we would gather notable academics, usually including a couple of Nobel laureates together to pose big picture questions. Not where should people invest today or what strategies and products should we look at developing tomorrow? UM, but how is the world going to

change in the coming ten years? And uh uh he joined our advisory panel two or three times, but he was always committed to work for the folks at Man Group. And as soon as Pimco UM recruited Manny Roman to become their new CEO. Turns out Manny had not only hired Cam Harvey also went to university with Cam Harvey and uh they were very good friends. So UM uh with UM, with the help of Manny, we went to Cam and said, hey, why don't you UM join us

in a more formal relationship. And so we're his dominant consulting relationship. We have access to a certain uh portion of his time. Uh. He is the guiding light for our R and D. He's already led some half breaking work in UM what's called pears trading. And when you

mentioned that you're a big fan of his work. One of the things I find fascinating is, unlike most academics, his work is squarely focused on what's practical, what's useful, and in modern academic finance, practical and useful are two of the most damning things you can say about somebody's work. If it's practical, oh my goodness, what use are they in academia? Uh? Well, I love that about camp. He's um uh tremendous innovator, deep thinker, and has been an

enormously important addition to our team. Let me ask about another one of your team members, your colleague Alex Picard, who wrote a fascinating piece um about bitcoin. And I thought this was really intriguing. So many people are sort of dancing around bitcoin given the run up they're they're afraid to get in the way of it. Picard road quote, Bitcoin is not a capital asset or a store of value. The price of BTC is nearly certainly a bubble and

likely manipulated. What are your thoughts on that? Well, firstly, you're asking the wrong guy, um um bitcoin. How do you value using discounted cash flow? How do you value something that has no cash flow and never will um. In that sense, it's no about no different from a dollar bill. A dollar bill has has a value, but discount of cash flow it doesn't have any. So the price of bitcoin and the price of the US dollar is exactly what the consensus in the marketplace thinks it

ought to be worth. In the case of the dollar, that moves slowly and sadly inexorably in the direction of worth less and less. Uh, it's worth on the order of one d when it was worse worse worth a century ago. In terms of purchasing power, UM. Bitcoin seems to move the opposite direction. But in both cases there is no There is no measurable value. There is no

way to say this is worth that amount. UM. So when Alex says bitcoin is near certainly a bubble and likely manipulated, my response to that is yeah, I agree. But the reason I say I'm the wrong person to ask is that, unlike Alex, Uh, I never bought much in the way of bitcoin. I think it was back in two thousand fifteen, I bought one bitcoin just as an item of curiosity to watch it, and um, I missed that entire boat. UM. I do think bitcoin is

a speculative asset. People talk about it as a replacement for fiad currency because the supply is strictly limited and is capped at a level that is not that much larger than today's out standing float. And they're right, but occurrence a fiat currency is used as a mechanism for exchange of goods and services and a store of value across time too, and it can't be a store of value if it's price PO goes around. That's a problem

with bitcoin. It can't be a means of transacting UM buying and selling goods and services because transacting in bitcoin has very large transaction costs, so it can't be a replacement for fiat currency. And as as such UM I wouldn't own it. But hey, my son a year and a half ago bought a UM, put his money half in Tesla and half in bitcoin, and at the end of last year sent me his statement which was up, and asked me, how do you do Dad? So I have to addend to being having been dead wrong on

both for a while. Now that's pretty funny. Let's talk about e s G for a moment. Some people have been making the case e s G environmental, social, and governmental styles of investing are a factor. You make the case that it's more of a theme ben a factor.

Please explain that what's the difference? Sure? Sure? Um? A theme A factor is something that can be clearly defined where the stocks um on the one side of the factor uh and the stocks on the other side of the factor strongly correlate with members of that same cohort, So growth versus value. Growth stocks correlate with one another. Value stocks correlate with one another, and the difference in performance has historically favored value and does so for a

reason that you can reasonably explain. E S g um. One of my colleagues did a test where he looked at a half dozen different vendors of E s G product at their definitions of what is an E s g um, how an E s G score is calculated for each company, and found that the correlation between s G definitions is shockingly not low, not that much above zero. So my E s G and R s G are likely to be very, very different. It's hard to create a factor when that's the case. I think is also

interesting and a little disturbing. Is it used to be called s R I UH Socially response investing. And back then the narrative was you want to invest in ways that align with your values, with your principles UM, and you can do so with a portfolio that's going to perform reasonably in line with the broad market. UM. Don't expect to win with SRI investing, but don't expect to give up much either. That narrative has shifted now. It

is with the s G investing. You can invest in line with your principles, and as more and more people shift over to E s G investing, you get a tail wind and you will outperform as well as UM. Aligning your investments with your principles, you you do well by doing good. In fact, you do better than the market. UM. Well, that narrative offends me because any time you you narrow your opportunity set UM in theory, you shouldn't be boosting

your performance. You should be degrading it. And you'd be boosting your performance only if E s G stocks were inherently superior. I have no problem with the s G. I have a problem with marketing it as a superior source of higher investment performance UM, and so I look at E s G as a major trend in the marketplace,

one that must not be ignored. One that indeed, we have offered product to help people invest in E s G in a fundamental index fashion that can beat the market because of fundamental index, not because of E s G, and we're pretty proud of that. But E s G stocks are trading at a large premium. That raises a really interesting question. And you've touched on this in three

separate groups of assets. One was domestically higher price. US stocks are trading pretty well, especially compared to Europe and Japan. Bitcoin there remains a firm bid beneath that that's doing well. And now E s G as a potential telwin was the phrase you used, which really raises the question for all of these tradeable assets. Is it simply a function of demand and supply if enough people want to buy something,

regardless evaluation. Arguably, we've seen elevated pe multiples in the United States, especially if we use the Schiller Cape index since the early nineties. At what what point is it strictly more dollars chasing fewer shares or coins, and that relative imbalance causes prices to go higher and higher. Well, what you've described as the nature of a bubble. Bubbles persist longer and can go further than anyone could possibly imagine.

My favorite example is Zimbabwe stocks, which during the summer of two thousand eight, when the currency was first going into free fall. Let's split the summer into first half

and second half of the summer. First half of the summer the currency fell um Uh fell tenfold in purchasing power in just six weeks, and Uh the Zimbabwe stock market rose five hundred fold, not five five hundred fold, five hundred times the price adjusted for the currency, it rose fiftyfold, meaning that if you thought this market's over priced and the currency has headed for a cliff, and

get me the heck out of there. Um. In fact, I'm going to make a modest short position at two short position, those six weeks would have wiped you out. You would be bankrupt, um because they two short position went up fifty fold. Okay, well that's daunting. What happened in the next eight weeks the currency fell another hundredfold in the stock market basically went to zero. So you were right over the next quarter, but bankrupt. So be very careful when dealing with bubble assets. Do not bet

against them. In any material way, but that doesn't mean you necessarily want to hold them. Very interesting. I know that you're a fan of motorcycles, and a couple of years ago they were described as underpowered toys. But there was a really interesting Hannah Elliott column and Bloomberg about the e V market for motorcycles is surging with exciting new possibilities, including some powerful bikes. What are you driving these days? What are you riding these days? And would

you ever consider an electric bike? Well? I absolutely would consider an electric bike. The problem with electric bikes today, and this isn't a problem with cars, UM, is weight. I mean, if you if you have a thousand pounds battery in a car, um, so what if you have a hundred pound battery on a motorcycle? That's a big deal. And uh so it disrupts the handling and the range is problematic. Um. In other words, I think electric cars are already at a point where they are practicable and

useful for anyone other than long distance driving. UM. And with motorcycles that's just not true. UM. I'm old enough at this stage that I don't really ride that much. I've been in Florida, um all of this year to date. Last time I was out of Florida was last October UM, and I won't ride in Florida, so I haven't written this year yet. Um. But bottom line is, electric vehicles are here to stay. Electric motorcycles are coming. It's just that the technology isn't there yet. Uh Uh. That said,

they are blindingly fast. I was looking at the arc vector and that thing is a bolt of lightning. Literally, it's quite fascinating. So let me ask you a different automobile question. I'm not a car collector. I'm a driver. I don't understand people who buy sneakers and don't wear them. Sneakers are for wearing cars for driving. That said, I'm kind of fascinated with the thought of all of these collectible internal combustion engine vehicles. What happens to that market

in thirty or fifty years. Will there still be people who can repair them, rebuild them, renovate them, or is this market, you know, on a on a short timeline. Well, short answer would be, of course there will be people who can repair them. Um. There's there's a market for anything that any that has enough customers that are interested.

And uh, I do you think twenty years from now, electric vehicles will utterly dominate the roads, and that self driven cars, cars that a human being drives, will probably be illegal because we'd be we'd be a threat. Um. Um, autonomous cars are going to be electric. Um. Can you imagine an autonomous car going to a gas station and saying fill her up versus just going to a recharging station and plugging itself in the ladder is very easy. Uh So with autonomous cars, you're going to have electric

vehicles utterly dominant. That means that today's collectible cars, almost all of them conventionally and powered, are going to be an anachronism and have no practical value. They'll have collector value, and there will be races where people take Ferraris and whatnot. Whether I think that means is, if you've got a Chevy um, it's going to be uh pretty pretty much worthless in ten to twenty years. If you've got a Ferrari, it'll have collector value. And um, okay, that's the nature

of a changing marketplace. Huh. Quite quite interesting. What are you streaming these days? Tell us your favorite Netflix or Amazon Prime show or whatever podcast you might be enjoying. Sure, my wife is Russian and so one of the things we love to do is is find an obscure Russian film or an obscure UH Russian TV series where she watches in the original language and I read the subtitles.

Um Uh. There's a UM Russian crime series from two thousand fifteen called The Method, which is about a fellow who solves crimes using all kinds of illegal methods to find and take take down the bad guys and a woman who um becomes more or less his apprentice, and ultimately his health is not very good. Um, so she really is his prospective replacement. And uh it ran for I think two seasons, and it was great fun to

binge watch. It's called The Method. Uh. Fantastic actress. She also appeared in a later UH TV series called Better than Us, in which she placed played the role of a robot that was able to have emotions and able to think and feel and um, therefore better than us. So anyway, too, wonderful Russian series. Very interesting. Tell us about your mentors who helped to shape your career. Oh gosh, there were so many of them. Um um um. Jack Bogel was a mentor. UM. Harry mark Owitz was and

still is a mentor. Um. Peter Bernstein was a giant in shaping who I am and how I think about investing. Bill Sharp. The list goes on and on. Um. Basically, I look to anyone, uh uh. And I still do this. I mean, I think it's fair to say I still have mentors, but I look to anyone who has insights that are interesting that I can learn from, and who has ways of approaching the business that I can emulate and seek to build. Very interesting. Let's talk about books.

What are some of your favorites and what are you reading right now? Oh, there's a fun book that I had last week called ten ten Trends that every smart person should know. It's an extremely fast read. Uh. It's extremely simple, and basically it looks at you know, the narrative is, look how many things are going wrong with the world, And this one just turns that on its head and says, look at how many things are going

right with the world. Life expectancy up um, the subsistence poverty was something like the world population uh thirty years ago, and it's dropped from eight um. And so it goes through a whole series of trends and basically poses the question, Hey, why why is everybody um so quick to criticize how the world is? The world has its flaws, but it's way better than it has ever been in human history,

and I thought it was just a marvelous piece. Another that I I love that I finished about six or eight months ago was four and four Two Big Tones, detailing how the Western world looked before Columbus and how the advent of global trade um U in the aftermath of Columbus has reshaped the world and reshaped opportunities the world over. Those are three really cool books that I

would heartily recommend. Very interesting. Let's talk about some advice for a recent college grad if they were interested in a career in finance. What sort of advice would you give them? Oh, my advice would be very very simple. Whatever you're taught from whoever teaches it to you, ask the question, um, is this true? Have people tested it? And um um? I think I could credit my career too the notion that uh. Basically I always asked the question,

has somebody tested this? If there's a bit of conventional wisdom floating around, I love to test it, and half the time I find it's absolutely correct, and half the time I find that it's absolutely false. And it's in that latter category where something is widely believed but false, that profit opportunities can be found. So be skeptical. These skeptical ask, and if you have access to the data,

test it very interesting. And our final question, what do you know about the world of investing today that you wish you knew thirty or forty years ago when you were first getting started. Yeah? Um uh, that's that's an easy one. Thirty or forty years ago, I was doing that stuff, testing conventional wisdom, often finding it to be wrong, and then publishing my results and having expecting people to say, Wow, this is cool, and instead the reaction was very, very often,

how dare you? How dare you challenge? Um? What we know to be true? Um? And uh. I wrote a piece in two thousand entitled Death of the Risk Premium, and about five years later met a guy at a conference and asked him how things were going, and he said, all things are going finally. Oh, by the way, I no longer hate you. And I said what you said? You wrote Death of the Risk Premium. You challenged everything I believed in investing, and I hated you for that.

I now realize you were right. Um, So thirty years ago, I used to be really disappointed when my work angered people. Now I just shrug it off. It's it's a given. If you up end somebody's worldview, they're going to be angry because they've built their career on the basis of a premise that you just demonstrated was wrong. Of course they're going to be angry, and so I roll with criticism. I'm almost amused by criticism these days, where thirty years ago it just um, I was things skin and it

really hurt. Well, Rob, thank you for being so generous with your time. This has been really fascinating. We have been speaking with Rob are Not. He is the founder and chairman of Research Affiliates. If you enjoy this conversation, be sure and check out any of our previous four hundred interviews. You can find those at iTunes, Spotify, wherever you feed your podcast fix. We love your comments, feedback and suggestions right to us at m IB podcast at

Bloomberg dot net. Sign up from my daily reads at Rid Halts dot com. You can check out my weekly column on Bloomberg dot com slash Opinion. Follow me on Twitter at rit Halts. I would be remiss if I did not thank the crack staff that helps put these conversations together each week. Maroufle is my audio engineer ATKO. Val Bron is our project manager. Michael Batnick is my head of research. Michael Boyle is my producer. I'm Barry Ridholts.

You've been listening to Master's in Business on Bloomberg Radio