Today's markets and Value's U-turn | Rob Arnott, Founder and Chairman, Research Affiliates

October 26, 2023 00:33:25
Today's markets and Value's U-turn | Rob Arnott, Founder and Chairman, Research Affiliates
FTSE Russell Convenes
Today's markets and Value's U-turn | Rob Arnott, Founder and Chairman, Research Affiliates

Oct 26 2023 | 00:33:25

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Show Notes

At the World Investment Forum in June 2023, Rob Arnott, founder and chairman of the board of Research Affiliates, shares his thoughts on Fed policy, interest rates and inflation from a historical viewpoint and where he sees them heading. He also talks us through the key findings of a RAFI research paper “Reports of Value’s death may have been greatly exaggerated” published in the FAJ in 2021. From there he explains the ‘migration effect’ on the dividend stream of the Russell Value portfolio from 2007 to 2022, the flaws in book-to-value and his thoughts on AI.

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Episode Transcript

Jamie: Rob, it's great to have you back talking with us again. It's always such a pleasure. Thank you so much. Rob: Well, thank you. It's a privilege. Jamie: Now, Rob, as we sit here, the market is facing quite a few macro headwinds and I'd love to talk them through with you. Why don't we start with the Fed? 'Cause they seem to be front and center of most macroeconomic debates. Do you feel we're in a point where they're pausing? Do you think they're gonna be easing? And how do you feel about the general interest rate environment right now? Rob: You know, I think the whole focus on Fed policy is misguided. Whatever they do; continue tightening, pause, skip, and continue, reverse course, it has an effect over such a long period of time that it is almost an irrelevant conversation. What makes it even more problematical is, have you noticed how well these folks can forecast inflation, GDP, unemployment? Their forecasts are worse, less useful than an extrapolation of recent trend. It's worse than a coin toss. Now they have 400 PhD economists. Harvard and MIT, between the two of them, have 100. So with four times as many PhD economists as Harvard and MIT put together, they can't forecast a damn thing. Now, if they can't forecast anything, why on earth do we think they have a clue about how to manage anything? I view the current situation with soaring interest rates with the worst bond market in history last year as entirely the Fed's doing. And we're looking to the Fed to fix what they broke. So I think there's a lot of deep structural error. It comes back to inflation itself. Inflation. Jay Powell declared that inflation was transitory in March of 2021. It was already 4%, half of which had happened in three months. 8% annualized for three months. So it was 4% in accelerating. And he says this is transitory. He retired the term transitory that November. So it had a nice eight-month lifespan. Now, roll the clock forward eight months from then, mid-year of 2022. Think back to mid-2022. The inflation was peaking at 9.1. What do you think the Fed funds rate was? Make a guess. Jamie: 3%? Rob: 1.2. Jamie: Was it really that low? Rob: They were 800 basis points behind the curve. And we expect these people to fix the mess that they're making. Australia's been called the lucky country because it went for 30 years without a recession. What did they do? Well, the long rate is set by the market. The long rate is the market's assessment of what the cost of capital should be for debt that is free of any default risk. You can think of interest rates as the reward for deferring consumption. Now, if you think of it as the reward for deferring consumption, it has to be above expected inflation. It has to be positive in real terms. Otherwise, you're not rewarding deferred consumption. You're rewarding acceleration of consumption, which in a neo-Keynesian world is seen as a good thing, but it's not. It means there's no investment for the future. Should the cost, the reward for deferring consumption be greater for 30 days than for 30 years? Obviously not. So an inverted yield curve is a perversion of the purpose of interest rates. And so what we've had is negative real interest rates, then inversion. Deeply flawed policies. Put this on top of blowout deficit spending globally that's beyond anything seen before in history. We've tried two heroic and horrific experiments. One being negative interest rates, negative real interest rates for a sustained period, and negative nominal rates in many parts of the world. And this yield curve inversion in a context of blowout spending. So think about that lucky country. What did Australia do for 25 of those 30 years without a recession? They had short rates, almost always a notch below long rates. It's almost as if- Jamie: Always an upward sloping yield curve. Rob: Yeah, it's almost as if their routine meeting was to say, "What's the long bond yielding? Okay, should we nudge this up or down to stay just under it?" Now in 1973, I think it was, there was a colonel in, US colonel in Vietnam, who was famously quoted as saying, "We had to destroy the village in order to save it." In war, that's a bad idea. In government policy relating to the economy, that's a bad idea. Why should you have to destroy the economy to save it from inflation? Now inflation is just a matter of supply and demand. If demand is elevated and supply is suppressed, you're gonna have inflation. It's that simple. So if you have supply depressed because of supply chain disruptions, because of people pretending to work from home, but not necessarily, because of people paid to not work, then the supply of goods and services is diminished. If you have airdrops of money into people's bank accounts, you have elevated demand. So of course you're gonna get inflation. Are we dealing with any of these? Yes, in modest ways. The airdrops of money are diminishing. The supply chain disruptions are fixing slowly but surely, but the problems are still there. Jamie: So let me ask you about that specifically. Which one of the levers controlling inflation right now do you think is sort of the most important? As you say, we've had this unprecedented stimulus packages for not just the past few years, but for several years. You know, we have supply tensions still going on. I know the US is currently in intense discussions with China. We'll see how that affects, but then this huge deflationary pressure of technology. And I'm interested on your views about which of these thematics or which of these headwinds or tailwinds do you think will come out on top? Rob: I was talking with a central banker, a senior central banker. It was in a session where direct quotes are not allowed or at least attributed quotes are not allowed. But anyway, I was saying, "It's clear to me that central bankers over the world are allergic to deflation. Is any distinction made between the types of deflation? Deflation can be a crashing economy. Deflation can be technological innovation revolutionizing some industry and leading to a surge in productivity, and hence economic activity." And to my astonishment, he said, "It doesn't matter. Deflation is deflation." Now, it seems to me the argument is often sticky wages. You get deflation, you can't reduce salaries. Well, what if you don't have to reduce salaries 'cause it's productivity surge? What if you have productivity suddenly grow 5% a year, some humongous number? And so you have 3% deflation and 2% wage inflation. What's wrong with that? There's absolutely nothing wrong with that. So we do have issues with misunderstanding of the role of interest rates, the role of money, and the nature of the macro economy. All of this goes hand in hand with a global takeover of Central Bank policy by neo-Keynesians. They'll argue that we have host of different views represented and arguing tremendously. A little like arguing over where to place deck chairs on a Titanic. If you have only one set of views ranging from neo-Keynesian to hardcore MMT to Marxist or whatever, that whole spectrum, you can argue that there's a spectrum. But Keynes himself would be excommunicated from the neo-Keynesian community. He would be because he had the view that you are welcome to use deficit spending to stimulate your way out of a recession, and then to use the subsequent economic expansion to replenish your coffers for the next round. That idea has been out the window on a bipartisan basis, and on a global basis for the last dozen years or more. Jamie: I was listening to Stan Druckenmiller talk recently, and he was saying that he feels like monetary policy makers are sitting on the Santa Monica pier and there's a 10-foot wave coming their way, and that's what they're focused on. But there's a 200-foot wave about a mile behind it they should be focusing on. And that's really that the deficit in the US is around 7% of GDP now, which is huge. I mean, France is like two to 3%. And by his calculations, in order to reduce that deficit gap, you would need to either raise taxes by 40% into perpetuity or cut spending by 35% into perpetuity. I mean, these are really big moves- Rob: Huge numbers. Jamie: in order to, and my question is, has the US been able to get away with this huge amount of spending because it's the reserve currency? Because like in the UK where I'm from, if they tried to get away with this, spending to stimulate, typically the home currency gets hit hard as Sterling did. Rob: Yeah. Jamie: But the US dollar is, because it's the reserve currency, does America just have this get out of jail free card? Rob: To some extent, that's true. Reserve currency status is, what was it termed? An exorbitant privilege or an extravagant privilege. Our reserve currency status is not at immediate risk, although we're sure sowing a lot of seeds for potential eventual demise. UK, the pound was the reserve currency for well over 150 years. And the US has been reserve currency since the 1920s, more or less. Now, are we putting that at risk? Yes, we are. But Larry Summers put it very succinctly. He said, what are you going to replace it with? Japan's a nursing home, Europe is a museum, and China's a jail. Well, his comment was an exaggeration on all three counts. It was, it makes the point in a very vivid way. Jamie: Yeah. Rob: The definition of reserve currency is very simple. It's what currency do people like to transact in? Jamie: Yeah, yeah. Rob: And if the majority of transactions have the dollar on one side of the trade, then it's by definition the reserve currency. Right now, I think the last numbers I saw was 60 to 70% with the euro, and the yen far behind in the euro. I think was in the 20 to 30, and pound and yen in the 10 to 20. So it's not at risk, but the policies we're pursuing do have the risk of debasing the currency even as a reserve currency. Reserve currency status doesn't mean that the purchasing power of the dollar can't tumble anyway. It just means that it's a preferred vehicle for transactions. Jamie: Yeah. So Rob, I do wanna get on and talk about research affiliates and the products you have on offer. But before we do that, we've spoken about growth versus value before. And myself included, there was many of us who felt that growth had had its time in the sun and with higher rates, this was gonna be a period for value to outperform. We have got the higher rates. It appears they are gonna be here for a while, but still, there's a lot of tailwinds in growth. I'm just wondering if I could- Rob: Very narrow sliver of growth. Big players, but small number of names. Jamie: So actually, what we're doing there is, we're talking about growth as a whole, but it's just a handful of the invidious of this world that are just taking that whole segment of the market with. Rob: I read the other day that the five most successful stocks this year in the S&P were the only reason it's up year to date. Jamie: Is that right? I haven't seen that maths before- Rob: Yeah. Jamie: but that might be right. Yeah. Rob: Yeah. So value went through the longest and deepest dry spell in history from 2007 to summer of 2020. Depends how you define value. If you define it on price to book, it was that full 13 years. If you use price earnings, it was from 2013 to '20. If you use price to sales, 2017 to' 20. Either way, it's a long dry spell and the 2018 to '20 period can only be described as a value crash. Value underperformed severely. Now, as a value investor, obviously that puts our company through a ringer and it has us challenging and testing our own assumptions. So we wrote a paper back at the beginning of 2021 in the FAJ. It got Graham and Dodd recognition as one of the two best articles of the year. Jamie: Oh wow. Rob: The paper was entitled, "Reports of Value's Death May Have Been Greatly Exaggerated." The basis of the paper was we did a research project asking, has value in fact died? Has it died? Are the critics right? And what we looked at, among other things, was the spread in valuation between growth stocks and value stocks. Now if you use a classic Fama-French formulation, you're using price to book. And in 2007, the spread in price to book between the growth stocks and the value stocks using Russell Growth and Russell Value for instance, was four to one. Growth stocks are more expensive. They're better companies and they deserve a premium multiple. But how much of a premium is the key issue? That went to 13 to one by the summer of 2020. It only reached 10 to one at the peak of the tech bubble. So this was tech bubble on steroids magnified. Now, what's interesting is that Russell Value peak to trough underperformed Russell Growth in terms of relative performance by 3,700 basis points over that 13-year span. Russell value got cheaper relative to Russell Growth by three to one. So if it's down 67% in relative cheapness and down 37% in relative performance, then that means the underlying fundamentals have actually been improving relative to growth. I'm actually gonna show an exhibit that shows this vividly. The dividend stream of a Russell Value portfolio from 2007 to 2022 has risen faster than the dividend stream of a Russell Growth portfolio. Jamie: Really? Rob: And it's not because the value stocks grow faster. It's because of what Fama and French called the migration effect. Value stocks, the value portfolio, you have individual stocks that percolate out of it suddenly get recognized as, "Oh, this company's not so bad after all." They're kicked out and replaced with deep value stocks. So if you replace a stock with an earnings yield of five, P/E ratio of 20 with one that's earnings yield of 10, P/E ratio of 10, then you're boosting the earnings base, you're boosting the dividends base, the book value base every time you rebalance. It's called a migration effect 'cause it relates to migration in and out of the list. The growth portfolio has the opposite. Stocks that are removed from growth almost always because they've fallen to too cheap evaluation. So if you replace a stock with a P/E ratio of let's say 15 with one with P/E ratio of 30, you're reducing the income stream, the dividends, the book value of the growth portfolio. So net of the migration effect or inclusive of the migration effect, I should say, the dividend stream for value, the book value for their value portfolio all grew faster than for the growth portfolio during the period of time when the value was getting crushed. Which means if the relative P/E ratio, relative price to book had stayed steady for those 13 years, value would've beat growth. So we pointed this out, we also pointed out the deep flaws of using conventional book value. And the result was a pretty compelling case that value stocks were doing badly, but value companies were doing fine. Now, markets move because of narratives. The narrative was with the COVID lockdowns, these tech companies are beautifully positioned for a world in which people work from home, in which people don't interact as readily as they used to. A world in which social interactions are gonna change, the way you buy and sell goods is gonna change. And the list goes on. And by the way, these bricks and mortar companies, they're toast. You're gonna see rolling bankruptcies. Well, lo and behold, with stimulus checks paired with a non-permanent pandemic lockdown, we found that the value stock survived just fine. Bankruptcies in 2020 were up modestly from 2019. Shocking that it was only a modest jump. Jamie: Yeah. Rob: And so the result was that instead of, the market was saying these value companies are going to do terribly as businesses, the reality was they were doing fine. So the snapback is something that we were predicting in the paper. What we weren't predicting was the current snapback in growth year to date this year. And that's on the back of AI. Jamie: Mm-hmm. Rob: The narrative today looks an awful lot to me like the narrative of the year 2000. Jamie: Right. Rob: Back then you had internet will change the world. It's a new paradigm. Pay no attention to profits or dividends because they're irrelevant. These companies are going to take over the way we do everything. Now, the narrative is that AI will do that. Jamie: Do you feel we're in a bubble then? Rob: Yes. But bubbles exist because narratives have the advantage that they're almost always at least partly true and often very true. But they have the drawback that they're already in the price. Jamie: Right. Rob: The current price reflects the accepted narrative. The accepted narrative right now is AI is gonna change the world in remarkable ways in the years ahead. I agree. If you've played around with ChatGPT or Dolly or any of these tools, it's astonishing what they can do. But the same could have been said about the internet in 2000. And I just completed a three-week trip in Europe. Is AI gonna change the way I'm driven around in cities? Yeah. It'll take time, but yes. The baggage handlers, not really. The chefs, the waiters in restaurants, the people who show you up to your room at a hotel, I'd say 80% of the people I interacted with, I was watching and thinking, "Is this person's job at risk on a five-year horizon?" 80% of them, I'd say no. Jamie: Hmm. Rob: Which basically means this is going to be a monumental revolution gradually. Jamie: Yeah. Rob: More gradually than people think. If I was a web designer, I'd be in a panic. Jamie: Yes, or a coder, yeah. Rob: If I was a mediocre coder, I'd be in a panic. If people talk about three to 400 million jobs disappearing in the years ahead, pardon me, but that's actually fairly normal. The US loses over 2 million jobs disappearing every month and two and a quarter million new jobs created. Jamie: Hmm. That's just the natural course of evolution. Rob: That's the natural evolution of business. And so as with horse-drawn carriages being replaced by automobiles, lots of jobs. The cliches, buggy whip manufacturers. But the list goes on and on. Jamie: Yeah. Rob: And is that horribly rough on the individuals whose jobs are affected? Of course, it is. Jamie: Mm-hmm. Rob: We should, as a society, be humane about that. But it doesn't mean saying you never have to work again, we'll take care of you. It just means we'll help you help yourself. So the AI revolution is very real. Does that make Microsoft, with its close tie with OpenAI, does that make them worth 12 times sales? I don't think so. That's a huge multiple of sales. Jamie: Yeah. So difficult to know what the sales number would be. You're just printing multiples on things you couldn't even possibly predict. Rob: Well, two jumbo cap companies, Microsoft and ExxonMobil. ExxonMobil, best of my recollection, is less than two times sales. Jamie: Yeah. Rob: So tacitly, that means that people expect that Microsoft's gross revenues are gonna grow sixfold relative to ExxonMobil. Jamie: Yeah. Rob: That's big. Jamie: So Rob, if you could explain to me the partnership products you have with FTSE Russell and Rafi. Rob: FTSE embraced the fundamental index concept way back in 2005. We brought the idea to FTSE at the suggestion of CalPERS. CalPERS wanted to embrace the idea. FTSE was the index provider for CalPERS. And so obviously, we had high odds of a near-term immediate client. So FTSE embraced the idea, ran with it, and it became a major profit engine. Russell came to us and said, "We're going to launch similar product. Do you wanna work with us on it?" And my original agreement with FTSE had, given a three-year exclusive, was six years in. So I said, "Sure, but it has to be different." They initially wanted it to be a clone and I said, "No way." So we created a complimentary, somewhat different, but think of it as first cousins. FTSE of course bought Russell. And so now, they're all under one roof. So you have FTSE Rafi and Russell Rafi, and upwards of a hundred billion managed using them. Jamie: I'm right in saying performance has been pretty great since COVID. Rob: Not since COVID. Since the launch of Rafi. To the casual observer, Rafi had a challenging decade in the 2010s. But keep in mind, cap-weighted indexes studiously mirror the look and composition and performance of the stock market. By definition- Jamie: That kind of momentum plays. Rob: But relative to the economy, their momentum plays, their growth plays their popularity weighted indexes. Jamie: Yup. Rob: Rafi is studiously neutral relative to the publicly traded macro economy. It weights companies according to how big is their current economic footprint right now. And so relative to the economy, cap-weighted indexes are stark growth portfolios. Relative to the market, Rafi is a stark value portfolio. So you can do a Fama French attribution and look at the alpha net of Fama French, or you could play it super simply and just say, "Okay, the value tilt of Rafi roughly equals that of the conventional value indexes on average over time." It's dynamic. When value underperform, we have a deeper value tilt than value. When value is relatively fully priced as it was in 2007, we have a pretty skinny value tilt. But on average, about the same value tilt as value indexes. Jamie: Mm-hmm. Rob: So the tracking error of Rafi Global against FTSE All-World is 5%. Against All-World value, it's 2.5%. So if you look at it relative to the value indexes, what we find is since the launch of Rafi during periods when value was winning, during periods when value was losing, during the value crash as it was happening, we beat the value indexes by an average of 1.5 to 2% per annum. Now, for 18 years, with 2.5% volatility. Jamie: That's great. Rob: So it's already got a t-statistic of three plus. So these indices have been stupendously effective. The challenge in the last decade has been a marketing challenge. People will inherently compare it with the cap-weighted markets. And whenever value's losing, we may be losing by less, but we're still losing. Jamie: Yeah. Rob: When value is winning, we're winning by more. So we're perceived as heroically hitting the cover off the ball. Now, how long can that continue? When if you compare it to the value indexes, you find it's just chug, chug, chug, chug relentless. Jamie: Right. I have one final question. You said earlier, Rob, that you wrote a paper talking about the valuation metric price to book, how you didn't think it was such a great metric to look at. Am I right? Rob: It's flawed. It's not a bad metric- Jamie: Okay. Rob: but book value was defined either early 20th or late 19th century. Jamie: The reason I'm asking is I'm wondering if now, is there a better way to value stocks? Rob: Oh absolutely. We use a composite of measures. If you look at price to sales, price to book, price to cash flow, price to dividends plus buybacks, these are all good measures and they are all flawed. So George Box of Box-Jenkins fame was fond of remarking that all models are wrong, some models are useful. And oh, I wish the quant community and the economics profession would embrace that. Everything we do in the quant community, everything that's done in the economics community is based on models that are wrong. But some of them are useful. So find out which ones are useful, use those. The pitfall with book value is that it leaves out all intangibles. We've all heard the cliche that our assets go up and down in the elevator every day. Jamie: Yeah. Rob: That is true of about half of all businesses today. The old bricks and mortars, businesses, a department store, it's not as true. The assets are the people for sure, but also the building and the product that they're selling. Jamie: Yeah. Rob: And that's a big sunk cost. So book value measures that. Now, what if you take book value and when a company invests in R&D, you add it to the book value and amortize it out. If I spend five grand on a nice desk, it goes right on the balance sheet as an asset. It's amortized out. If I spend 5 million on R&D, it's treated in accounting land as if it was just a discretionary throwing away or burning of assets. Now, I don't spend that on R&D if I think it's going to not come back. And so think of it like a desk, add it to the book value, amortize it out. If after 10 years it hasn't paid for itself with room to spare, then it was a dumb idea. Same as a desk that turned out not to have needed. So when you do that, Fama French price to book, the value investor today is five times as wealthy as the growth investor from 60 years ago. So if your grandparents bought Fama French value, their next door neighbor bought Fama French growth, you would've inherited a portfolio that's worth five times as much as the descendants of the next door neighbor. All right, well, that's great. If you threw in just R&D, nothing else, just R&D, you would have 10 times- Jamie: Wow. Rob: as much money. So price to book can be made roughly twice as effective for the long-term patient investor by incorporating R&D. You can also incorporate a portion of the administrative side to the extent that somebody spends money on patents, on brand building through advertising, and so forth. Those expenditures are justifiably treated as investments and therefore added. But that's trickier because that's all in baskets that also include ordinary operating expense. And so the one piece that is easy to carve out and say, "Well, this is investment," is R&D So that was a, in that same paper, it really could have been two papers, but it was a twofer. Jamie: Yeah, well, such an important thing to discuss right now as people try to work out whether stocks are overvalued or not. Rob, it's been so fantastic chatting to you. Thank you so much for your time. It's always such a great conversation. Rob: Well, I have thoroughly enjoyed this nearly two decade long partnership, and I look forward to many years to come. Thanks, Rob.

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