Transcription
I don't think AI is a bubble. I think AI stocks are a bubble. There's a difference.
Markets in the short run are voting machines and in the long run are weighing machines. The voting is American exceptionalism is real. Let's bid this this thing up cuz it's got nowhere to go but up. The weighing machine would say US is at roughly twice the valuation multiples. The narrative is AI will change everything and it will. But the narrative also says the companies leading the AI charge today are poised for extraordinary growth. And then one or two of them might be. But there's also the issue of um um transforming AI into profits is proving to be rather difficult. Our work suggests that small cap value will beat large cap growth by on the order of 700 basis points a year on a 10-year horizon. That's enough to double your money relative to sticking with growth.
Rob, welcome back to Access Returns. Glad to be here. It's great to have you on again. Our audience is very familiar with you. Hopefully, you've been on multiple times and we always appreciate having you on. You're known in uh the investment world as I think one of the most influential speakers on quantitative investing, fundamental indexing and really just a student of of market history that we can always learn um a lot from you on. And so today we have a wide variety of topics. I think some may be more evergreen than others that we want to talk with you today. That includes looking at some of the recent research that the firm has put out talking about how you're looking at market valuations and future returns. And then maybe to start we'll get into I think some of the more maybe you can call them short-term but things that are going on in the market that I think investors are thinking about including what's happening over in Iran and how investors should be thinking about that AI and some other stuff. So really appreciate you joining us. Um, you can always learn more about Research Affiliates and access the research that these guys are putting out at researchaffiliates.com. And we'll put links to some of these research papers in the show notes as well. So, anyways, thanks Rob. Hopefully that was not too long of an intro, but I want to give you that because that's important.
>> Yeah.
>> Um, so yeah, to start, let's I mean, let's let's talk about what's sort of on the news and what's front and center with this Iran conflict. I mean, a lot of investors are sort of asking themselves, how is this going to affect my portfolio? Should I be making adjustments? But what I wanted to ask you, what's important is to try to look at, you know, what does the study of market history tell us about the impact of conflict and whether or not investors should be letting stuff like this influence their portfolio?
>> Um, historically, war has uh not been particularly damaging to stock and bond investments except in the losing country. And so um um the markets the global markets shrugged off Ukraine and to this day uh the tragedy of what happens in war uh notwithstanding uh the markets focus on what's happening in the global economy. Now, um, one of my favorite economists, Charles Goff, um, a brilliant French economist, sounds like an oxymoron, but it's true. Um, uh, uh, is fond of saying that GDP is energy transformed. That is to say, you take energy, usually oil, and you turn it into prosperity. And uh yes, over the course of decades, economies become more energy efficient. That is to say, more dollars of GDP per barrel of oil, but it's still the dominant source, fossil fuels are still the dominant source of energy powering the entire planet. Um and so uh a major oil producer that's 5% of world's supply that also has um potential to close off the straits of Hormuz through which 25% of world oil supply passes uh has the potential to be massively disruptive. So this is not Ukraine. Um this is um uh potentially a big deal which is why very aggressive strikes very fast and obliteration of Iran's navy so that they have less chance to um close off the straits uh are are important elements here. The the other issue that I think is is equally important is um what's the exit strategy? And if the exit strategy is to leave a uh collapsed economy run by unknown uh zealots or dictators or whomever, um then what you've probably done is take much of 5% of world energy supply offline for a fairly long period of time. So we don't know what the endgame is. We don't know how it'll play out. I do have a plaque. uh you um were kind enough to share that question with me ahead of time. I do have a plaque that used to be on the desk of John Templeton. John Templeton was a legendary investor from the 1940s and he had a plaque on his desk that said trouble is opportunity. Um it was gifted to me about a decade ago and u it's a useful reminder. People worry about trouble and they should but they should also think in terms of what are the investment implications because tumult creates opportunities. So uh often times tumult creates market reactions that are sometimes uh overreactions. So you can have opportunities to contrade. The um uh liberation day April 2nd was beautiful example of that. The market severely overreacted to tariffs that were of unknown eventual magnitude that turned out to be more of an economic than anything tremendously influential.
Is the higher than you know average valuations here in the US. Does that at all or could that at all play into maybe this being a little bit more of a delicate situation given what's going on? I mean, how do valuations sort of or do they at all sort of factor into how you might kind of be looking at this?
>> Well, Ben Graham famously said that the markets in the short run are voting machines and in the long run are weighing machines. The voting is American exceptionalism is real. Let's bid this this thing up because it's got nowhere to go but up. The weighing machine would say US is at roughly twice the valuation multiples whether you're using cape ratios or uh dividend yields or price to book value roughly twice the valuation multiples of the rest of the world. And so I do view that as an extreme opportunity, not necessarily horrifically bearish for the US, but um very interesting opportunity to build positions and diversification and risk reduction by deploying money elsewhere in the world. Elsewhere in the world is also uh likely to be more affected than US markets by the tumult in the Middle East and we certainly saw that the last few days. I I view US expensive markets in the US as being vulnerable but more from a perspective of opportunity best opportunities lie elsewhere. And when you're looking at expected returns, you guys have a tool on the site where you do asset class and market expected returns. I think 7 to 10 year returns. Are there any where in the US looks attractive? I think like large cap growth probably long-term returns less than historical average, but are there any pockets in the US that do look more attractive to you based on your estimates?
>> Well, firstly, the spread in valuation between growth and value is historically extreme. Uh it's been wider than this uh only in the aftermath of the COVID value meltdown uh in the summer of 2020. uh the spread between growth and value in various valuation metrics, price to sales, price to book, dividend yield, price to cash flow, various metrics have the spread between growth and value uh roughly as wide today as it was at the peak of the dot bubble.
Okay, well that's a little alarming. The narrative is AI will change everything and it will. But the narrative also says the companies leading the AI charge today are poised for extraordinary growth. And then one or two of them might be. But there's also the issue of um um transforming AI into profits is proving to be rather difficult. The capex outlays are stupendous, estimated to be $600 billion uh next year. Well, that's a lot of money to spend when you don't know how to get that money back. So, so, uh, one of my colleagues, Chris Breitman, is writing a paper that's coming out in a few days on exactly this topic. Uh, the spread between large cap and small cap is the widest ever. No exceptions, the widest in history. And we have a paper coming out um CFA institute has a research foundation. So like financial analyst journal that publishes academic articles the research foundation publishes more in-depth monographs longer than the uh uh papers and uh we have a monograph coming out shortly um I think it comes out in maybe next month uh that looks at the active side of indexing. Indexes are thought to be passive. They're not. They uh mostly are if they have 5% turnover, you could think of it as 5% 95% passive, blissfully indifferent to what's going on in the individual companies or the economy or the market. Um just along for the ride. The 5% um looks like a crazed growth investor um buying stocks that have soared at lofty multiples, selling stocks that have tanked at deep discounts. Now, why do I mention this in the context of small cap? Well, small cap isn't in the big indexes, whether you're looking at S&P 500 or Russell. And as money flows into index funds, it flows out of things that aren't in index funds. So the spread in valuation is now um uh better than 2:1 between S&P 500 and Russell 2000 uh in terms of relative valuations. And here's the fascinating thing. The companies that aren't in the index have had 2% peranom faster growth in the underlying business over the last 30 years than the companies that are in the top indexes. 2% peranom faster growth and they're priced at a 50 50% discount today. That's fascinating. So if if your audience anyone in your audience doesn't have a towhold in small cap, put it in place. Uh it should be a decent slug of your portfolio. And it has been nice as a factor investor myself uh you know for years we've been talking about value we've been talking about international we've been talking about small cap and actually when I tell people about it now they're they're actually excited about it you know in past years for for many years they were like you're an idiot what are you talking about now it's actually working to some degree so it is it is it is nice to at least see some results.
>> Yeah. Uh the uh look for that monograph when it comes out um because there's a wonderful graphic in it that shows the divergence between relative valuation and relative performance of the underlying businesses. It's relentless.
So I want to switch and ask you about AI and I don't know did you get an opportunity to read the Satrini piece? It sort of took the world by storm here.
>> It's it's a really interesting paper and I think there's a lot of truth in it but I think the truth is somewhat overstated.
>> Yeah. And it was meant as a thought exercise which which I kind of enjoyed it from that perspective. Like I think people who took it as this is the way the world's going to be, you know, we're attacking it and going crazy. Like for me, I feel like I know a lot more about AI because I read it and because I thought about the concepts within it. And one of the things I thought when I read it is I I thought we have Rob coming up and I want to ask Rob because you're you're really good at thinking about things from the long term. And one of the things that that struck me about the paper is we have this idea that in the long term AI is going to create a lot of jobs, which I think is probably true. It's it's going to create a lot of jobs. But we also have this push and pull with this idea that in the short term it's going to both maybe enhance us in our careers but it also might destroy a bunch of jobs. Um and if it's a more transformative technology it might destroy more jobs than other technologies have. So how do you think about like that balance between all that?
>> Yeah. Um every technological revolution in the history of mankind has killed millions of jobs. Um uh if they had job statistics back when fire and uh uh the wheel were invented, I bet you would have seen lots of jobs displaced. But but you know whether it's the steam engine or um uh the cotton jin or um railroads or telephone and telegraph or uh cars and trucks and and uh airplanes or computers or the internet or the AI revolution. Every one of these killed millions of jobs. And that's devastating to the people who are displaced and find, oh, I have skills that are no longer useful. I got to find something totally different to do. Um, but a generation later, um, those jobs aren't missed. Computers displaced computers. It used to be a computer was a job description. Somebody who was very quick and facile with math and uh could do complex equations faster than um anybody else in the office. Okay, that was a computer. Does anyone want that job now? Uh I don't think so. Computers can do all that stuff a billion times faster with absolute accuracy. So um um when it comes to social interaction, social media, that sort of thing, lots of jobs displaced, the newspaper industry upended. Um does that create new jobs? You bet. And the same will hold true for AI. Anyone who's not thinking about how can I use AI to do my work better and faster is an idiot. Um, it is very powerful. Uh, fun little anecdote. I'm I'm uh kind of old-fashioned. I like to do initial research in Excel because it's so quick and easy. Um uh uh and so I'll have research team put together data into an Excel file and then I'll play around with it. Um, we got a uh I had them put together a file of all US companies for the last 70 years with what was their return for the year, what were their valuations ratios and construct rafi fundamental index raqi our cap weighted index a cap weighted construct to compare attributes and so forth. And I asked one of our programmers, um, doing this for 70 different pages on the monster spreadsheet is time consuming. Can you set up a macro for me? Uh, and he he said, "I don't know. I haven't done macros." And he said, "But let me take a look." He got back to me less than an hour later and said, "It's done." Um, and I said, "How did you do that? You found a you learned how to do macros in less than an hour?" He said, "No, I asked Chad GPT to write it and um uh it put it together. I tested it. Works fine. So, here you go." So, cool. That would have been a day or two or three of his time if he had to learn how to do macros. It would have been three or four hours of my time. Um, uh even though I know how to do macros. Um, and GPT just flung it together and it worked. So cool. It's funny, too, because I just uh I haven't used it a ton yet, but I just Claude has a plugin that you just install straight into Excel, and I think there that's probably pretty promising, too, is just to have these working for you right inside the spreadsheet, too, if you'd prefer to continue using Excel.
>> Notwithstanding the um uh uh uh other war going on right now between the administration and anthropic. Uh it bears mention that our uh we pulled our IT people and our programmers with which tool they most like to use and anyone relating to programming at all it was unanimous. Claude cool.
>> Yeah, I'm kind of I do programming as well and I'm kind of the same way. Like I use Claude code all the time now uh to build interesting things. You know, one of the interesting things you said to us last time you were on or maybe by the time before that I think relates to what you were just saying is this idea that you had once called an all hands meeting of research affiliates and you had basically told people LLMs are not going to replace you, but people who learn to use them could. And I think that's the idea like that stuck with me ever since like I've been thinking about everything I try to do in my life. I'm like how can this enhance what I'm doing? How can this make me better at? And I think that's the attitude we we all have to have with this.
>> Yeah, that's exactly right. Think of it as a tool. Uh it's an extremely powerful tool. Um in fact it's a an astonishing tool and um it interacts in the most complex programming language in the history of mankind. It's called English. Uh the the notion that you can ask questions and get a reasonably reliable answer. Yeah, it still hallucinates. Um I asked it what the all-time high was for Cisco during the dot bubble and it came back with a date in 1999 and I knew that was wrong. So I said, well, what was the high in 2000? And it came out with a totally different and higher number. So the first answer was a hallucination which I I knew enough to know it was wrong but you know you ask a human researcher they're going to get things wrong too. So um it's it'll change everything but one of the interesting challenges is how do you make money if you're creating AI? If you're creating the hardware that runs AI for the moment, that's super easy because you've got people on waiting lists wanting to spend tens of thousands of dollars per chip to buy your AI hardware. But AI software is currently run at a massive loss by everyone who's offering the AI tools. And so one of the fascinating things is we're going to get there. It'll be profitable. The question is when and how. And uh so we'll see.
On this treaty piece like one of the things I've been thinking about a lot is is this we can learn from all the other innovations of the past, but is this kind of innovation on steroids because it's intelligence? And do we think about maybe we magnify both the long-term value of this in terms of what it's going to create, but we also maybe magnify the short-term pain in terms of because it is intelligence, it could replace more human jobs. I mean, do you think that's a fair way to look at it?
>> I think that is spot on. I think that it will be more disruptive um uh perhaps than any technological innovation since um computers since um the railroad. I mean, back in 1825 to get a message from uh Washington DC to New York, it had to be on horseback and it took 2 to 3 days, even if you were replacing horses uh every every um uh 25 miles and just kept going. 100 miles a day was your maximum. um uh 20 years later it was um took one day uh because of the railroad and 10 years after that it took u milliseconds because of the telegraph. So there have been some humongous technological innovations. Um AI I think will be one of those. Now the leaders of AI today may not be the leaders of AI in 20 years. That that's why the massive capex spend because they want to secure their place in the pantheon of leaders and feel that they have to spend hundreds of billions. I mean Zuckerberg said as much um he said the cost of spending a quarter trillion um on capex is horrific. The cost of not spending it may be much more horrific. And um there's a lot of truth in that. But the question of is is it going to change our lives? Yeah. In more ways than we can possibly imagine. It'll be massively disruptive. The most I think the most disrupt technological disruption of my lifetime and I've been around for a while.
What do you think the most important things are for investors to think about with this? Like when I talk to clients, they're always asking questions like, "What is my exposure to AI? I want exposure to AI, but I think maybe the lessons from past booms may teach us that that may not be the right way to approach this." So, how do you think people should think about inst AI from the perspective of an investor?
>> Well, you can have um firstly, the narrative that drives the bubble is a narrative that says this is going to change everything. And that narrative goes on to say that the key players, the dominant players have a moat that'll protect them and it'll be very difficult to displace them. Difficult doesn't mean impossible, especially if you're looking at a multi-year horizon. U it also goes on to suggest that the change will happen very fast. I mean AI that can relate to you in English has been with us since late 22 uh when chat GPT was introduced. Um boy what an innovation. The the uh but how many people spend more than a few minutes a day trying their hand at exploring what AI can do for them? I would venture to guess that at least 90% of the population doesn't sit down and try using AI to explore what it can do for them more than a handful of times a week, if that. Um, there's 2% of the population that spends hours every day exploring it and they're going to own the future. So, uh, we all owe it to ourselves to to learn.
You have a great practical definition of what a bubble is. Um, one of the more practical ones I've seen. And I'm just wondering if if you could talk about what that is, but also how are you thinking about do you think AI is a bubble based on your practical definition right now?
>> I don't think AI is a bubble. I think AI stocks are a bubble. There's a difference. Um our definition of bubble is very simple and that is that if you're using a discounted cash flow model um uh kind of a Gordon equation type thing to value um uh an asset that you would have to use implausible growth assumptions to justify the current price. Uh not impossible but implausible. So, Amazon, as one example, in the year 2000 was priced at levels that required what was then reasonably thought to be implausible growth assumptions. And sure enough, it was a disaster for the next decade. And then it got its mojo and it was no longer priced at levels that reflected implausible growth expectations. And sure enough, it became a wonderful stock. um one of the most successful stocks of the last quarter century but not in the first decade of that quarter century. So um there are companies that go on to achieve growth greater than what you would need to justify the current price. Amazon and Apple are two vivid examples. The growth required to justify the price in 2000 has been exceeded for a quarter century. Cool. But those are the exceptions that prove the rule. The vast majority um we've talked about this in the past of the 10 most valuable companies on the planet in the year 2000 only one Microsoft is still in the top 10 only one Microsoft has come anywhere near be uh beating the S&P 500 and it's only beat it by a couple percent a year um of the 10 most valuable tech stocks in the world the median result has been a negative return over the last quarter century. Over half of them have had negative returns. The um um ones that have been wildly successful, Qualcomm has seen 60fold growth in sales in the last quarter century. 60fold. And yet it's behind the S&P 500. Why? Because it was priced to achieve that in 10 years, not 25.
I want to ask you about margins because that's something we've been talking about for a long time. Like as a value guy, I've been one of these people who's been saying margins have to mean revert and they really haven't been mean reverting for a long time. So I'm just wondering like first of all if you have any thoughts on that idea in terms of why margins haven't mean reverted, but I also want to bring it back to the idea of AI and like do you think AI could lead margins to continue maybe to go to higher levels than than we think they could go to?
>> Mean reversion has been uh central to my career, central to everything I've done. Uh valuation multiples tend to mean revert. That is to say, if they get stretched, they're more likely to mean revert than to go further in the same direction. Doesn't mean they can't. It just means that they're not likely to go further in the same direction. One of the areas where mean reversion operates most powerfully is um profit margins. Why? Because if you have a stupendous profit margin, you're going to attract competitors galore. And it doesn't matter how wide your mode is, somebody's going to figure out a way to get past it. Uh Intel was the fourth most valuable company on the planet in the year 2000. It had a moat. Nobody could touch them on making chips and doing it uh inexpensively with huge margins. Um and nobody could touch them until they did. And then Nvidia, Taiwan Semi, AMD, ASML, all of these wound up surpassing um uh Intel over the subsequent 25 years. But it took time. I mean, Intel was still the dominant chip maker 10 years after in 2010 and just slowly but surely frittered away its its advantage. Another interesting warning sign is uh the more dependent you are on government laress the more likely you are to not have a successful mode. So, uh, I when the chips act was passed, I thought what horrible news for Intel, a $50 billion bailout from the government. What horrible news and of course they've gone on to achieve great disappointment.
>> It's funny, too, because thinking about these moes in real time is so hard to do. Like, for instance, if you had asked me a few years ago about Google's moat in search, I would have said there's no chance. Like or before 2022 like they've got such a strong moat and like when you're living through it these companies seem so dominant but now we've got chat GBT so now I've seen a way in which Google's moat could be challenged and I think that's the case with a lot of these big companies in history at the time it's hard to see it but then in the future something comes you didn't think of.
>> Yeah, we talked about this last time that um uh using AI as a search engine Google's entire business model was predicated on uh sponsored links and sponsored pop-ups. And without those, it has no profits. And then all of a sudden, people realized, oh, I can use uh AI as my search engine. I'll get no sponsored links and no pop-ups. How cool is that? Uh so Google itself had to decide we're going to disrupt our own business model and erode our own margins by introducing AI as part of our search engine because if we don't disrupt ourselves we're going to be disrupted out of business. Um and then uh uh chat GPT itself was disrupted by deepseek supposedly created on 1/100th the resources of chat GPT and the initial re uh uh the initial version of deepseek was rated to be as powerful as chat GPT 4.5. All right. The other thing that's interesting is how fast AI is evolving. GPT 5.2 two is phenomenally more powerful than 3.5 and the hallucinations are way down. Um uh it's just it does feel like you're talking to typing to a person who has multiple PhDs and has um intimate knowledge of more or less all of human knowledge. It's so cool.
Do you think on the idea of mean reversion, do you think there's a case that it's been slowing down? I mean, I think we, you and I both believe mean reversion is still a very powerful force in markets, but you could argue margins haven't mean reverted like you'd think. You could argue some of these big tech companies have grown at rates that you thought weren't possible. Valuations have taken longer to come back than people think. Do you think you could argue that the process of mean reversion has just slowed down for some reason?
>> I'm not so sure about that. I I I think mean reversion has always been choppy and sluggish and uh feels like a random walk, but it's a mean reverting random walk. And when a company's at frothy multiples, one of two things has to happen. Uh the fundamentals have to catch up with the price or the price has to revert back to the fundamentals. So you're going to get mean reversion on the valuation multiples for sure, but it can happen one of two ways. And and and so the question on defining a bubble is would I have to assume implausible growth for it to close with the fundamentals catching up? Uh that graph in the upcoming paper that that looks at um the relative valuation and relative growth of fundamentals for members of uh the indexes and non-members is just a fascinating case study. Does this mean that we're going to see mean reversion in the next year, next 5 years, um for small cap and value to mean revert towards large cap and growth? Um not necessarily on a short horizon, I would say high odds on a long horizon. And that's because we've seen it happen again and again and again. Uh the Nvidia has vast margins uh so does Palunteer so do a host of others but they're com to some extent they're competing with one another not so much Palunteer and and u Nvidia uh one is a user the other's a supplier but they wind up having competition and competitors coming that if your horizon is 3 to 5 years, there will be competitors. I don't care what your mode is. Within 5 years, if your margin is 50%, you're going to have competitors. And um on a 10-year horizon, the likelihood of your margin being uh remaining as far away from industry norms uh as they are at the start of the decade is really remote. Uh so I do see mean reversion coming in the profit margins. Uh uh very high odds and and the interesting thing is people think that I'm poo pooing the AI revolution. I'm not. I think the AI revolution is very real and is going to continue to surprise us for years and years to come. Um, I'm just questioning who's going to come in onto the scene that uh will have better ideas and displace some of the leaders and who are the end users who are going to benefit in ways that can't be anticipated. Um, ultimately I think the big winners uh may be organizations way outside of the tech arena. I mean, if you're running a trucking company, uh, if your dispatcher isn't using AI to figure out what trucks to move where, you're behind the curve and things like that are coming.
You had mentioned international stocks before and maybe we've kind of hit on a little bit of this, but when we had you on previously and we were asking about how you were investing your personal portfolio and long-term assets, you know, you were pounding the table on um emerging market value stocks and that ended up being a a phenomenal call. And so, you know, what I wanted to ask you related to international is obviously the last couple days it's been kind of painful if you're new to allocating to international.
>> Yes.
>> Yeah. Little little uh but that's kind of to your point, you know, those those international markets going to be more expect more impacted from things like this than maybe the US at least initially here. But what I want to sort of ask you is if you were trying to convince someone, you know, if you look across most US investors portfolios today, strong home bias, very little international, like if you were trying to make the case for allocating towards international, you know, how would you do that? How would you emphasize sort of the long-term market history, the risk and diversification that international gets you? And then kind of going one level deeper like where would you be focusing that would it be broad-based international exposure would you be a little bit more developed I mean
>> Unless unless you want to take the time to dive in and study individual markets uh broad-based exposure is I think the right answer um fundamental index has been more powerful in emerging markets than in developed markets I think because they're less efficient uh fundamental index for those of your uh viewers who aren't familiar with it simply says instead of creating a portfolio that looks like the stock market, let's create a portfolio that looks like the publicly traded macroeconomy. Meaning that you choose companies based on how big they are. You weight them on how big they are, not on how expensive they are, not on how big their market cap is, but how big are their sales, how big are their profits, and so forth. Um, in an inefficient market, well, firstly, in any market, if you cap weight, stocks that are trading above their eventual fair value are overweight in your portfolio. So, you're overweight the overvalued companies. You don't necessarily know which ones they are. That's the that's the problem. But if you break the link with price, then companies that are overvalued might be overweight or they might be underweight. Companies that are undervalued might be overweight or might be underweight. The errors cancel. And so there's this rebalancing alpha that's worth about 2% a year. And that's that's not speculation or theory. That that's actual observed results. In emerging markets, it's more like 3 or 4% a year. And so, um, you can buy, uh, fundamental index-based ETFs and mutual funds, uh, that will give you broad diversification that won't pull you into putting most of your money in the countries that are the most expensive. It'll put you into the countries and companies that are most important to the global macro economy. And if you do that, you get broad diversification. You get risk that's not dissimilar to conventional cap weighted indexes, but you you you capture that mean reversion alpha. If a stock sores or if a country soarses, country stock market soarses and its underlying fundamentals don't, uh, a rafybased portfolio will say, "Thanks for the nice gain. Uh, I didn't see any fundamental validation for it. I'm going to trim it." And that rebalancing alpha is just really powerful.
Is there anything with the long-term trend in your opinion on the strength or weakness of the US dollar and how that might play into that as well? I mean, I know, you know, most of these strategies don't hedge currency or anything like that, but I'm just curious on if you have any feelings on on on that.
>> You know, it's interesting. I was at a um uh conference u uh just a few days ago where uh there was a panel discussion on the dollar. And when I went to this meeting a couple years ago, the the question was um uh why invest uh uh anywhere else when the dollar is clearly the strong currency and going to continue to sore. Um, and then this this go around it's why would you invest um uh in the US when the dollar is going to continue to tank and um uh mean reversion happens in currencies too. They can get ahead of themselves. I think the dollar looks a little weak. Uh, one of the things I like to do is use a CPI adjusted currency and then you can compare them around the world and the US dollar is a little on the cheap side relative to where it's been in the past. So, um, uh, that's one very minor um, argument in favor of maintaining that US um, uh, focus. But um part of the tremendous strength of international and emerging stocks in the last few months has been um dollar weakness.
I wrote a great paper recently uh trifecta fundamental revolution in indexing and you just talked about the first leg of the trifecta with Rafi here. But before we talk about the different legs, I just wanted to maybe see if you could talk at a high level like what were you trying to accomplish with this paper?
>> You know, when we developed fundamental index back in 2004, uh we knew we were on to something important. And it's become a there's almost $200 billion invested in fundamental indexes around the world. Um and probably a similar amount invested in imitating and otherwise similar products. Uh so that's a lot of money. Uh it's probably the most successful non-cap weighted to index in the world. Um when we developed that we knew it was going to be important. We discovered we thought if you choose companies based on how big they are and weight them based on how big they are, you're going to get a rebalancing alpha. You're going to get a value tilt. Um I thought this will probably add 50 or 100 basis points a year. No. In back testing, it added over 200. Live, it's added over 200. When compared with an appropriate valueoriented cap weighted index like the standard cap weighted value indexes, the outperformance has been relentless. What I didn't realize at the time was that one of the core uh attributes of Rafi, it involves fundamental selection, not choosing companies based on how frothy and expensive they are, but based on how big their business is and fundamental waiting, waiting companies based on how big their business is. Fundamental selection also works for cap weighted indexing. The cap weighted indexes. Imagine I said to you, I've got a great idea. Been working on this and I'm really excited. We will buy a stock. Any stock that has soared past a certain threshold and on average it'll be priced at twice the market multiple. On average it will have beat the market by about 75% in the last year before we buy it. But it's clearly on to something and it's headed for great things. Now, some of them don't work out. My sell discipline is the opposite. We'll sell it if it tanks below that threshold. Could be top 500, could be top thousand. Um, and on average, we'll sell it for half the market multiple and on average we'll sell it after it's underperformed by 7,000 basis points. But, you know, most of these companies do go on to good things. What do you think? You want to invest with me? Uh described that way. It sounds like an absolute dithering idiot, but that's the way indexes trade. And it's because they buy into this mantra that markets are efficient, prices are efficient, and so yeah, if you want representative stocks that mirror the look of the stock market, you're going to cap weight because the market's cap weighted and you might as well cap select because otherwise you're including companies that are too small in market cap to matter. Well, it turns out that you can use fundamental selection not just for creating raffy but for creating a better cap weighted index and for creating a better growth index. So the essence of trifecta is we decided to launch a better cap weighted index back in 2021. We did the work in 2020 and 21. We launched in 21. The ETF was launched last year. He started working on can this also be adapted to growth investing and did that um uh back in 2023 to 24. Index was launched in early 25 and um uh I'm not allowed to speculate on whether ETFs might be in the pipeline or not but um uh it wouldn't be shocking. So you can use fundamental selection to choose better growth companies to choose better represent representative companies for a cap weighted index and to have a better better value strategy. That's a trifecta. If you have a um worldclass value strategy, Rafi, a worldclass capweight index, RAW, and a worldclass um fundamentally selected and fundamentally weighted growth strategy, Rafi growth, and it works everywhere in the world. And they add value with statistical significance everywhere in the world. That's a trifecta. So, um I'm excited. Uh I I feel like I'm a septtogenarian getting ready to launch another revolution. It's just a hoot.
Would there be a way to combine all of these three things into one index?
>> Absolutely. But let's start with your core index fund. If your core index fund uh chooses companies based on their market cap, based on crossing that threshold, you're buying stocks that are frothy and expensive after they've soared. And by the way, you missed it. Um if it underperforms badly enough, you're going to drop it after it's underperformed. And by the way, you wrote it all the way down and you're selling cheap. Uh if you can mitigate that by choosing companies where the fundamentals are now big enough to matter regardless of price level. Um then you have a more powerful core cap weighted index and it has 99.9% correlation with the S&P or the Russell 1000 or for global investors the AQE. Um, all right. 99.9% correlation. That's pretty cool. And ballpark of 50 to 100 basis points incremental performance. That's pretty cool. So, that's your better core. Now, what's another way to do things? We have a paper coming out in the next issue of the financial analyst journal. I think it comes out also next month called fundamental growth that looks at our research in applying fundamental index principles to choosing growth stocks. And what we find is if you choose stocks based on how fast they're growing, percentage growth, and then weight them based on the dollar magnitude of that growth. So you're waiting them in proportion to their contribution to the growth in sales and profits of the total economy. You wind up with something that over the last uh 30 years beats Russell growth by about 4.5% a year. Very cool. Um, okay, Rafi beats the value indexes by 2 to 2 and a.5%. Rafi growth wins historically. It is a back test, but it's a very simple back test. It's not data min uh four and a half. Let's haircut that and say maybe it's going to be two and a half the same as Rafy in the future. You could put those two together and say I'm instead of buying Raqqi, I'm going to put half my money in Rafy and half in Rafi growth. Instead of adding 50 to 100 basis points, I'm going to add two to 2 and 1/2%. That's really cool, but it's not an inclusive index. It doesn't span the market. It leaves big chunks of the market out. So, you have um companies that are uh u cheap and andor growing slowly. Those would be considered standard value stocks. Um, well, we want cheap, but we don't want sluggish growth. Um, if you have stocks that are expensive and growing fast, we want we call that a growth index. It's treated as a as a simple linear binary choice. It's either growth or value. Throw that out the window and say if it's cheap, it's value. If it's growing fast, it's growth. Now you're leaving out companies that are expensive and growing slowly. That fourth of the market historically underperforms the market going back and and this we're able to test way back. We've tested it um back over 50 years. Uh going way back um that quadrant of the market underperforms by 2% a year. If you're lagging by 2% a year for 55 years, uh guess what? You are um uh less than a third as wealthy as you could have been. So leave those out and you wind up with a strategy. I'll call it a strategy rather than an index that captures the best of value and the best of growth. It's not a core index in the sense that it leaves a fourth of the market out.
What I love about the research that you guys put out, Rob, is that there's always these little like I'm going to use the word nuances. It's probably not the right word, but like this conglomerate piece that your colleagues put out. Like it's like somebody had to think about okay what did conglomerates look like in the past and what type of valuation did they command or maybe not command and how does that stack up like relative to today's conglomerates that investors sort of see in in the index. And so, you know, I just think it's a very it was I thought it was a great paper and I think let's just kind of talk through I think maybe some of the things that you found they found and maybe some of the possible takeaways for investors. I mean to start based on the historical data it looks like conglomerates have had this diversification sort of discount as the paper called it. So can you kind of just help us work through what that actually means?
>> Um back in the 60s uh u conglomerates were priced at a premium uh substantial premium and that was because gosh they can put their money anywhere the opportunity is. Um um ITT uh um was not ATT, ITT was a famous conglomerate that was involved in telecom and uh transportation and retail and everything else under the sun. And the narrative was um the management can steer company resources to wherever the growth is. And boy, isn't that a powerful tool? And so what we uh found at the time was that they were priced at a premium. Then it turned out that running too many desperate businesses, you're not liable to not be very good at some of them and you're liable to be reactive uh chasing what's been successful um rather than anticipatory putting
money into businesses that are poised to take off. And so we went from a conglomerate premium to a conglomerate discount.
Now you've got big businesses. Several of the Magnificent Seven are diversified into a wide array of businesses and the narrative is they've got it covered. So, so we're back to a premium and the question is are some of them going to stub their toes and turn out to be not very good at choosing where to allocate their resources?
Um, for example, that $650 billion of anticipated capex next year on uh data centers um uh and other uh infrastructure for AI. Um they're all chipping in a hundred billion here or 150 billion there adding up to those lofty numbers. Are some of them going to turn out to have wasted their money? Probably. And then the diversification premium, the conglomerate premium uh can go back to a discount. So um I'm that's not a projection, it's it's a scenario that is possible that gets very little attention today.
>> Yeah. One of the charts you had in here for Amazon, Apple, Alphabet, uh Microsoft, you kind of show the revenue makeup starting in 2015 and how, you know, these businesses have gotten more diversified, gotten in more sort of non-core services over the last 10 years as they've looked to kind of expand, you know, their business model into some of these areas that maybe might not be as they might not be as good at. They they may not be as profitable as what the core businesses are.
>> Yeah. If you're Apple, how are you going to move the needle on on uh business the size of Apple's with a new iPhone? Come on.
>> Right.
>> If you're Microsoft with a a new software package, no. And so the presumption is, well, we got to find something to do. You don't have to find something to do. You can return the money to the shareholders. You can say, "We've done a great job for you. Here's a bunch of money for you. You figure it out." Now, companies don't like to do that because they uh have the hubris that we know way more than our shareholders do. And they do in their core businesses, but they don't when looking at the aggregate opportunity set in the macroeconomy.
One of the sort of charts in here shows that this conglomerate premium and right now when you take those four, you know, mega cap tech companies, it looks like it's, you know, uh, on average they're trading at a 70% conglomerate premium.
>> Mhm.
>> What do you think sort of how how would you what explains that premium?
>> Is >> narrative set prices. The narrative that these companies know what they're doing and they are building our future and you better get on board or you're going to miss it.
>> What do you think that sort of implies for I mean these are the largest companies in the market today. So what would that what implications does that have for sort of market cap weighted investors?
>> I think um I think we are likely to see a pivot back to value. Value is very nearly the cheapest it's ever been. You'd have to see value stocks beat growth stocks by 100%. Have they'd have to double relative to growth stocks just to get back to historic norms for relative valuations. Small would have to double relative to large cap in order to be um back to historic norms of relative valuation. Now I'm not saying small cap is going to double or value is going to double but some sort of mean reversion where they move in that direction is certainly possible.
If you look back uh again at the.com bubble as a wonderful example, the narrative coming into the.com bubble was get on board this internet thing is huge and it was and these internet companies are going to be stupendously successful and some of them were but they were also priced as if they were going to be even more successful. And so the narrative was these companies are where you where you got to invest cuz that's the future. Well, the first two years after the bubble burst, let's say March, let's choose March of 2000 as the bubble bursting. The first two years after that, uh NASDAQ was down uh a little over 50% by March of 2002 on its way to a drop of just under 80%. Um S&P was down 27% on its way to a 46% drop. Um Russell value was down four, Russell 2000 was up four and Russell 2000 value was up 53%. So you literally tripled your money if you pivoted from NASDAQ into Russell value at that moment. If you had the precience or the luck to choose that moment.
Um on a 10-year horizon, our work suggests that small cap value will beat large cap growth by on the order of 700 basis points a year on a 10-year horizon. That's enough to double your money relative to sticking with growth. I'm not saying get out of growth. Um uh partly because who knows what the right timing is on this. But um also because people will get cold feet if they make the move at the wrong time. What I am saying is fade some of your winners. buy into what's out of favor and cheap and just kind of lightly average in to um uh increased exposure to what's um newly cheap.
Just in closing on this, like the article, you know, started with the story of GE and it kind of came all the way to the late 90s when Jack Welch was, you know, doing all these rollups and making GE into this like massive conglomerate. And I just remember, you know, in in the late 90s, early 2000s, I think my timing is right here, where GE was top of the food chain, you know, was the preeminent company was maybe the most valuable company in the S&P 500. And, you know, then it sort of all came to somewhat crashing down. I mean, the company has turned around now. They split off different units and stuff, and it's been much better as they've kind of realized the value of the different parts of the business. But I think the point that stood out to me as I was reading this is you see those lists of for each decade the most valuable stocks in the S&P 500 and for his all of history that we have market history for they've always been different and they've always been changing. And so that's kind of what really sort of made me think when I was reading this article. I'm like, you know, when we look out 10 to 20 years from now, the most valuable companies today are probably not going to be at the top of the list. I don't know if you agree with that or not, but that's kind of what it made me think of.
That's that's a reliable pattern. The the companies in the top 10, on average, seven or eight of them are gone within 10 years, no longer in the top 10. And on average, eight or nine of the 10 underperform the market over the next 10 years. Now, sometimes 2010s being a vivid example, there were only two winners um uh uh Apple and Microsoft out of the top 10, but they beat the market in the 2010s by enough that the top 10 list actually did fine. But in most decades, no. The the top dogs uh the very business practices that propel you to being a top dog are suddenly decrieded as as predatory. And so regulators are all over you. Um uh your competitors are gunning for you. Your customers are no longer fans of you because you're too big for your britches and you're too arrogant. Uh so uh staying a top dog is really hard.
Rob, thank you very much. We're looking forward to following all the great research that you guys are putting out. So please uh don't be a stranger. You're welcome back anytime.
Thank you.
>> Thank you so much. This has been great fun.
>> Thanks, Rob. Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network at excessreturnspod.com. If you have any feedback or questions, you can contact us at excessreturns pod@gmail.com. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.