5 Things We Learned in 2019
publication date: Dec 25, 2019
author/source: Brian Nelson, CFA
5 Things We Learned in 2019
"The further a society drifts from the truth, the more it will hate those that speak it." -- George Orwell
By Brian Nelson, CFA
I'm looking at the beautiful Smoky Mountains in Tennessee as I'm writing this piece. I hope that you and yours are having a wonderful holiday season with family and friends. I wanted to share with you a few things that I think investors learned during 2019. Before I do, however, you're probably wondering why I decided to lead in with this particular quote from Orwell. ---
The quote, in some ways, is a reflection of how I think many approach truth in finance. Maybe they don't hate the truth, but many in finance are simply indifferent to it. In some ways, indifference is worse than hate. At some point, many decades ago, finance seemed to stop looking for the right answer. It's almost as if they just pitched the public on efficient markets and index funds, and then created a body of research, any research, defending it. The body of research didn't even have to make sense.
They didn't care that active funds represent less than 20% of the stock market, and that research on underperforming fund managers says little about whether stocks are mispriced. They didn't care that the Arithmetic of Active Management actually says that for each dollar of underperformance, there is a dollar of outperformance (more on costs later). They just used it to sell more index funds. They even sold the public on believing that stock pickers are so talented that that is why the level of potential outperformance is shrinking.
Frankly, I don't believe much of what gets printed today. I feel bad about the current state of finance. The reality is that the average active investor can outperform, net of fees (we showed the theorem in Value Trap), and it is my firm belief that the reason why professional money managers are struggling today is not because they are all so talented, but rather that many have become too influenced by quant. Remember -- for every dollar of underperformance, there is a dollar of outperformance. It's just simple arithmetic -- somebody is winning. Stock selection doesn't come with fund fees or even commissions, so the cost matters hypothesis just isn't relevant to stock selection.
I recently talked to a financial advisor that worked with a large financial media organization, and I explained to him that I thought financial advisors could effectively pick stocks. He not only laughed at me, but he then told me that I thought too much of advisors. Well, for starters, I do think highly of financial advisors that put their clients' interests first. I believe financial advisors can further differentiate their practice with stock selection, and I not only believe they can effectively select stocks, I know they can.
Finance today, however, is operating within a construct in which very little that gets printed represents actual truth. Instead, what gets printed and shared more broadly represents more of what the sales machine wants others to believe. Evidence-based and empirical are the latest catch-phrases. My goodness -- anything that has ever happened--and I mean anything--is evidence-based and empirical. These terms mean very little, and they are now everywhere in finance, a behavioral science!
What's more, for those that do believe in the traditional empirical approaches, the only thing that empirical asset pricing models have shown is that empirical asset pricing models fail in real-world testing time and time again. Yet, some keep demanding more and more "empirical." It is the strangest thing. Instead of the quant foundation being dismissed as wrong, finance wants more and more empirical risk factors that are just turning out to be spurious. There's something very, very strange happening out there. We know incentives are playing a part in indexing, maybe regulations are causing some of it, too, but let's get to the bottom of it. Something's not adding up.
Finance has gone so far down the wrong path that today there is even debate as to whether stock prices are a function of future expectations. We know they are. People aren't investing for the past. They're investing for the future. Finance cannot possibly try to explain returns with realized ambiguous price multiples that take into consideration a yearly snapshot metric such as earnings or EBITDA when we all know that prices are based on future expectations of free cash flow and consider the balance sheet of the entity. Yikes! Worse, the debate continues to center on things like value versus growth instead of simply dismissing most of financial quant as simply the incorrect way to approach a behavioral science. Finance has all the wrong answers!
Furthermore, it is almost painful to hear some financial advisors pitch the benefits of index funds because they are low cost, and then layer the same fee as that of an active manager on the index fund. It seems the industry is just trying to take advantage of the popularity of index funds in doing so. Financial advisors simply know that diversified stock selection doesn't come with fund fees, and now commissions are even free! The cost matters hypothesis just doesn't hold water anymore. If financial advisors are truly pursuing customized options for clients, there may be no real excuse for not pursuing diversified stock selection, or a managed portfolio, as the equity allocation these days.
We're already starting to see some changes across the industry. The investing public is starting to catch on to some of the shenanigans. For the first time since 2008, Bank of America clients bought more individual equities than they did ETFs. According to CNBC, "Bank of America clients bought $38 billion worth of stocks in individual companies in 2019, exceeding the $25 billion worth of ETFs they purchased." Investors are coming around to the idea that index and passive investing is not something for all types of markets, and that fees attached to such approaches make little sense. I maintain my view that paying attention to one's holdings and knowing them inside and out will always be the best answer when it comes to investing.
Every year, I work to learn something new. Below is a list of 5 things that I think investors learned during 2019. In some ways, the list goes into topics that many may hate to learn the truth about, but I feel that if we can accept such things, we as a field can work comfortably toward the right answers and building businesses that adopt practices that embrace the right approaches. We can't be afraid to speak the truth. When most of finance is going in the complete wrong direction, we have to make it popular again to say and do the right things. Without further delay, here are 5 things investors learned during 2019.
1. Economic Moats Underperform
In a recent piece from the CFA Institute, summary statistics measuring Morningstar's economic moat ratings revealed that the returns of wide economic moats underperformed the returns of narrow economic moats, which in turn, underperformed the performance of companies with no economic moats--exactly the opposite of what many may have expected, but consistent with the framework of enterprise valuation.
Based on equally-weighted portfolios from July 2002 through August 2017, wide-moat stocks underperformed no-moat stocks by 4 percentage points and 6 percentage points per year on a geometric and arithmetic mean basis, respectively, over the period studied. It is simply a myth to believe that wide moat stocks outperform. Warren Buffett's process includes enterprise valuation. We talk about enterprise valuation and why wide moat stocks underperform in our book Value Trap.
Don't hate me. It's the truth.
2. Factor Investing Jumped the Shark
In a piece from the University of Chicago, the school notes that factor investing is getting a bit ridiculous, at least in how we read the paper. The title of the article, "The 300 secrets to high stock returns" is an absolute gem, as by itself, it hits exactly at the abuses of the statistical quant community.
The reality is that most of ambiguously-defined factors based on backward-looking and often impractical data will not hold up in time. The surge in factor investing coincided with the sales process of ETFs, and many ETFs in the $50-$100 million range have been closing down. We expect a further fallout in quant finance, as factor investing falls into the background.
Don't hate me. It's the truth.
3. The Growth Versus Value Conversation Is Nonsense
Warren Buffett may not have been the first to say there are not really growth and value stocks, and I may not be the last one to pound the table on this dynamic, but let me say it again: There are not really growth or value stocks. There are either undervalued stocks, fairly valued stocks, or overvalued stocks.
2019 marked another year where the quant community was left answering questions about whether the traditional quant value factor makes any sense, and by extension, whether most all factor investing makes any sense. AQR's Cliff Asness may have hit the nail on the head with the well-researched size factor, " It Ain't What You Don't Know That Gets You Into Trouble -- "It's what you know for sure that just ain't so." There is no size effect.
It seems like the quants are so sure about so many things that just aren't so. You can learn more about how quant value is failing in walk-forward testing, how the size effect may not exist, and just about how every key foundational theory in quant may not hold water, all in my presentation to the Los Angeles chapter of the AAII here. If a factor does not consider a forward-looking price-to-fair value metric, it is likely spurious.
Don't hate me. It's the truth.
4. Fair Value Investing and the Valuentum Methodology
Valuentum put together another fantastic year for its members. Remember -- Valuentum is an investment research publisher, so we only do well when our research works and our clients do well. We have lots of skin in the game, in this respect.
The Best Ideas Newsletter portfolio outperformed the S&P 500 this year, by our estimates, and we continue to deliver on the track record in the Exclusive publication. Many take the outperformance for granted, but please understand that this is far from normal in an environment where many are being charged 1-2% to invest in index funds.
Don't hate me. It's the truth.
5. Changing People's Minds Is Not Easy
It has now been almost 5 years since we made our landmark call on the MLP space in 2015, explaining the universal nature of enterprise valuation when it comes to stock returns. It was one of the boldest calls, perhaps in the history of finance.
Our team wrote our first book Value Trap explaining the story in the Preface, and we think we've made a tremendously positive impact on the industry, especially when it comes to improving transparency and helping investors make better decisions.
We have a lot to overcome with our thoughts on quant investing, as we debunk Nobel prize winning work, and we understand that it's hard for academic avenues to throw decades of work by the wayside (e.g. finance is still teaching the CAPM, something that makes little sense). However, what's wrong is wrong, and what's right is right, and we're going to keep working hard to mold the field of finance.
Let me ask you: have we as a society drifted too far away from truth in finance? What do you think? With all of this said, may you have a wonderful holiday with you and yours. From the Smoky Mountains in Tennessee, thank you so much for being here.
Let's make 2020 even better than this year!
Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc
Tickerized for holdings in the DIA.
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