Preston Pysh  6:00  

I’ve got the next question. This one has to do with an interview that we recently had with a person on our show two weeks ago, Toby Carlisle. He was talking to us about deep value investing, which involves the purchase of a company that typically has some value trap indicators to it. What makes your approach different from his? Because one of the things that Toby was saying was that he wants one of the ugliest companies that he can find in order to get the biggest gain out of it in a short duration after he would purchase it.

Andrew Sather  6:33  

I definitely listened to that. I think it was great. There were a lot of great ideas and opinions. Definitely, when you get into things like deep value, there’s a lot of risks that can come with it. But again, that’s where the reward comes from. So you got high risk, high reward. Have either of you heard of Ted Williams? He’s a baseball player. He is one of the best hitters of all time. Have you heard about Ted Williams?

Preston Pysh  6:59  

I’ve heard about him, but I don’t know that much about him.

Andrew Sather  7:02  

Ted Williams played baseball. The way that batting average works is that, not only do you have to make contact with the ball, but you have to make contact with the ball and get on base. That’s how you get a high batting average.

Back when Ted Williams used to play, a good batting average was like 300. Ted Williams was able to get a batting average of 400 in a season. So he’s outperforming the average by more than more than 10%. His secret to successful hitting was not, “How am I going to focus on what’s the best ball to hit?” He said, “I’m going to focus on what are the best balls not to hit.” 

By reducing the strike zone and segregating it, he figured out which balls have the greatest percentage of him getting on base. As a result, he set many records. He became one of the greatest hitters of all time, and when people think about great baseball hitters, they think it’s Ted Williams.

I tried to take that approach with investing as well. You know, the Value Trap Indicator is a quant-based metric. So there are a lot of similarities to a lot of the other quant-based metrics. Everybody has their own valuation they like to use. Buffett had his Owner’s Earnings. O’Shaughnessy had his What Works on Wall Street. He had the price-to-sales. He had the price-to-book, and then he incorporated momentum as well. He had Benjamin Graham with the cigarette butts and the PB. So, these are the different metrics that people like to rely on.

The thing that makes the Value Trap Indicator different is that instead of optimizing for how much overperformance can we get with one or two metrics, it provides a fail-safe for when one or two metrics are not good, then that’s when we’re going to stay away. So, we’re not optimizing for what’s the best opportunity. We’re looking at what are the pitches that are coming our way that might look great, but in reality, there’s not as high of a percentage, and we’re just going to avoid those.

And so, by taking a lot of various valuations, we try to cover our bases and avoid those situations that might lead us into bankruptcy. The saying goes, the only thing you have to fear is fear itself. Well, if you can understand how bankruptcy works, you’ll never have to fear bankruptcy, so you’ll never have fear in the market.

Preston Pysh  9:22  

I love it. That is fantastic, and I really like your point about Ted Williams. So, good points, Andrew. That’s awesome. Stig, go ahead with the next one.

Stig Brodersen  9:30  

So Andrew, would you care to provide a few stark examples of great companies that investors might have been thinking were profitable stock picks at a great price, but proved to be value traps.

Andrew Sather  9:43  

Yeah, sure. So I think the obvious one is Lehman Brothers. Everybody kind of thinks about that when they think about these crazy bankruptcies that made everybody just get so surprised. You had Lehman Brothers by every metric of profitability. They seemed to be just the perfect company. Look at their income statements, flawless. They had growth. They had a low P.E. ratio and a low price-to-book ratio. All of these things looked great, even the cash flow — discounted cash flow and free cash flow. They were superb in all metrics except the debt-to-equity. So they had a debt-to-equity of 29.

To put that into perspective, a company with debt to equity usually is around one. When you have a company that’s financial like Lehman Brothers, it’s usually around 10. So, even in financial terms, they were three times more leveraged than the average financial. When you talk about 29 times more leverage than the normal company, you have a crisis. Of course, they’re going to go under. So that’s one example of a company that looked great on the surface. But if you look at everything, then you’ll understand that the debt-to-equity was really too high.

Another one that I actually wrote about on my blog was about this company. I was doing the screen and I was looking for some great value. I wanted a high dividend, among other things. I found this company called Atlantic Power. They had a dividend over 10% that time. Even the debt-to-equity was great. It was like 0.23. 

If you know Graham, you know that he likes high current ratio. So you’re looking at over 4 at the current ratio. I mean, that’s the kind of thing that Graham would like. The price-to-book was very low, but there was one little concerning metric: the earnings were negative for the year.

I wrote about it and I warned on my blog that this is a value trap, stay away. It looks really juicy, but you just got to stay away from it. Luckily, for people who follow my advice, that stock tanked from like the 8 or 10 range down to like the 2 range and it’s hovering around $2 a share now. Those are the types of things that can really hurt your returns as a value investor. Because, to be honest, when you’re searching for value, you do get a lot of high returns, but the problem is that your average return will lower if you’re getting these big drawbacks as well. That’s what I try to prevent.

Stig Brodersen  12:06  

So Andrew, I can’t help but think. Now you’re talking about bankruptcy, which of course is like the ultimate value trip, but what about time? Could you share your thoughts on that? Because I guess time is a major cost too for you as an investor.

Andrew Sather  12:20  

When you’re looking at something like the Value Trap Indicator, it’s a very conservative metric. You have the opportunity costs and there is a good chance that you might miss out on some great returns. The way the Value Trap Indicator works is that I really look down strongly on things like leverage. 

A lot of times, that keeps you out of the financials and those types of stocks. But if you turn around enough stones — I mean, there’s over 6000 stocks just in the US market and there’s so many opportunities out there. When you’re looking at the financials, yes, you might miss out on the big returns when they recover, but at the same time, you miss out on a lot of the downfall and a lot of the drawdowns that come along with that.

So I think it is a strict balance and you do have to consider “What’s my opportunity cost I’m losing?” But at the same time, “What’s the opportunity cost of a stock that rises 300% but has the P.E. of 1000?” That’s something you have to consider, as well. So, it’s really just a person’s preference for risk. It’s really what you’re comfortable with, and it’s really what you’re trying to avoid. 

Because I’ve been so immersed with the bankruptcies, I tried to share about all that research with the book I have coming out soon called Value Trap Indicator. Knowing all those things, I’m able to be very strict on my evaluations. If it doesn’t meet one evaluation, it’s because there’s a reason. These are the types of symptoms that a company has experienced before.

Preston Pysh  14:02  

Andrew, it’s funny because one of the big things that I pulled out of Security Analysis with Ben Graham was: he talks about this idea of whenever you’re assessing a business and something that you’re getting ready to invest in, he always starts with the mitigation of your potential risks first. 

He’s talking about, “Hey, look at the debt-to-equity. Look at the current ratio. Look at, on your income statement, your coverage ratio”. All these ideas really revolve around “How much debt is the company taken on?” versus “How much are they earning and how much are they going to have to pay back?” He always starts there. That way, he can make sure that he doesn’t get into a value trap situation like you’re referring to.

After he’s basically made that determination that he feels that the company is safe and the earnings in the future will continue to produce enough income to pay those debts, that’s when he goes in and figures out what he thinks the intrinsic value of the company is. He won’t even go to that second step until he figures out whether he feels like it’s a safe investment. It totally syncs with what you’re telling our audience here, and how important it is in order to make sure you mitigate this risk first.

With all that said, it kind of leads into my next question. I think a lot of people out there and a lot of investors do not have this strong background that you might have — or like Stig — in accounting, where they understand all this terminology like current ratio, coverage ratio, and things like that. And so, I guess the question that I have is for a person that might not have that strong background in accounting or a firm understanding of these indicators, do you think it would be more beneficial for them to focus on index funds to lower their exposure to risk?

Andrew Sather  15:39  

Believe it or not, I actually don’t have a background in accounting whatsoever. I’m just a guy who really likes diving into the books and I kind of picked all this up as I went along. So don’t think that you have to get four years at a university with an accounting degree in order to make this stuff work. You can do this all on your own, but it’s not easy. At the same time, you do have to put in the time and the study.

That being said, with the Value Trap Indicator, as I mentioned in my book, even though we are looking at these bankruptcy cases, if you follow these methods, you will stay away from 96% of the bankruptcies, or whatever the number may be. But there’s always that small chance of a company that, for whatever reason… I mean, this is the stock market, this is real life. Things happen that just nobody can predict or nobody’s models can predict. This is why you have to diversify your risk. You have to be diversified. You need to spread your investments over many different types.

I mean, even looking back at the previous bankruptcies, there was a company called Monaco RV. They were a very cyclical company in the sense that they depended on consumer demand to make their earnings. They had a very strong balance sheet. Everything checked out. 

I mean, the Value Trap Indicator said it was a strong buy. Everything looked great, even the CEO at the time. So, they interviewed him afterwards, and he said, “We should have stayed liquid and we should have stayed open, but the banks wouldn’t give us money.” So, for whatever reason, they hit a rough patch where they had one bad quarter. And then, all of a sudden, 3000 people lost their jobs. The company went under.

So, you have these situations where even if a company is well-run… Like I said, 96% of the bankruptcies I looked at, they were predictable. There were big red flags that say these companies are in trouble. But there’s always the off case that a company could go bankrupt just because of a crisis, or because of the banks, or whatever it may be. 

We don’t know what the future holds. This is why if you have a diversified portfolio of a group of stocks. You are lowering your downside risk and you are making sure that one little freak accident doesn’t screw up your financial future.

I don’t think you have to be an expert to really profit from these concepts. You could literally just pick up a book or two, apply what you learn, and you’ll be fine. But for the people who maybe want something that’s a little bit less involved, definitely, an index fund is something that you should go for. 

At the same time, these are concepts you need to understand. If you’re holding an index fund and it goes down 50% during the bear market, and you sell out, you’re just in as bad of a situation as if you hadn’t even gotten an index fund at all. So you need to not only understand these concepts, but process them, use them, and make sure you’re doing a long term strategy. Index funds are also a great way to do that.

Preston Pysh  18:43  

I really liked that last point. Because I think a lot of people think, “Oh, yeah, I’m just going to buy an index fund because all that stuff’s really hard to understand. I just don’t know what they’re even talking about, so I’m just going to buy this index fund.” 

And then, like you say, it goes down 50%. Because they don’t understand the inherent nature of what it is that they own and they don’t understand what it’s all about, they sell out because they’re scared. The fear is induced because they lack the knowledge. So, I really like that point. I think that’s a very strong point. 

Even if you just educate yourself a little bit, you’re going to understand that markets move in cycles. So if it goes down, you have an opportunity to purchase more equity. Those are basic things. Even if you don’t go down the rabbit hole as far as some of us have, I think just understanding some pieces of it are going to help educate you, so that you stay strong during that, and you increase your position. Go ahead, Stig.

Stig Brodersen  19:36  

Preston, I think that’s a really good point because often, you hear the really brilliant business people that do understand everything there is about accounting and how to select individual stocks, they still invest in index funds simply because it’s easy for them. They don’t need to monitor the companies as much as they have to if it’s individual stock picks. But still, they make really good returns because they understand the process. 

For instance, as Preston was saying — as you were saying too, Andrew — they do not sell even if the index fund loses 50% price. Don’t think that because you are selling individual stock picks, you need to be really, really smart. All the opposite. You can actually do both. That actually leads me to the next question, Andrew, because I was thinking: “If I really want to copy what you were doing (more or less, at least), what is your own investment process for avoiding these value traps? Could you just take us through the process, perhaps step-by-step?”

Andrew Sather  20:38  

Yeah, definitely. So there are three financial statements that every company is required to file by the SEC: the income statement, the balance sheet, and the cash flow statement. If you look at those statements, they actually tell you a different picture. If you can understand what that picture is, you’ll understand the process a little bit better.

So the income statement really tells you how’s the company doing right now —  What’s their health right now? The balance sheet is what’s the company looking like long term — Are they a good company? Are they strong financially? Do they look like they have a great future? And then the cash flow statement is a really great place to look at what the performance is going to look like in the next few years.

A lot of value investors like to jump on to the cash flow statement. It’s a great place to go, because you have the free cash flow and the discounted cash flow. By looking at what these cash flows are doing now, oftentimes that formulates what happens in the next few years coming up ahead. If you look at it in those three ways, you really have to understand that you need parts of each statement in your analysis, or else you’re missing the whole picture.

What the Value Trap Indicator does is it takes seven categories. We have some from the income statements, some from the balance sheets, and some from the cash flow statement. If any one of those metrics look out of whack, if any one of those metrics trigger a red flag, then automatically, it’s either going to be a strong sell or we’re just not even going to get involved with that stock. 

That does preclude us and there is some opportunity cost lost there, but the value of being able to sleep at night knowing that I’ve done everything I possibly can, and I’ve looked at every situation that could possibly be negative and I’ve accounted for that, really, to me, that’s priceless. That’s kind of what the Value Trap Indicator does. 

Obviously, I break it down in the book and we look at every single category, but those are the main things that we look at. It just takes one. Like I said, Lehman Brothers. That’s equity over 29. With just that one metric, we’re not going to buy it even though for years and years and years, it looked great. It was one of Fortune 500 top companies. Everybody was saying praises of it, but it just takes one metric. That’s why we avoid those types of situations.

Preston Pysh  22:55  

I think that you using Lehman is a very good example because most of the time, when you see a really ugly company like… let’s go back to 2007 / 2008 and look at GM. Their numbers were horrible. You could see it across multiple variables. 

But his discussion about Lehman is really important because Lehman had a lot of good indicators across the board and they had one sore thumb that was really sticking out. And that should be enough for investors to really say, “You know, there’s just something not adding up here. There’s something that’s being pushed into this corner over here, and it’s not making sense.”

If you find a fantastic business, you are not going to see something like that. If you pull up Berkshire Hathaway today, you’re not going to see anything on there that shows a value trap indicator like what you might see in some other businesses. So you need to be very picky and it goes back to Andrew’s original example with Ted Williams in hitting: he was making sure that he wasn’t swinging at any of the pitches that had a low probability of not getting a hit. 

I really like the fact that you keep coming back to Lehman because a lot of companies when they start looking ugly, it’s ugly across the board. But you need to be very choosy in what you select. So with that said, Andrew, if you can narrow down your value trap to two major indicators, what would you say those two indicators are?

Andrew Sather  24:18  

That’s a really great question, because it’s simpler than you might think. We use all these big terms and all this jargon and it sounds like, “Oh my gosh, it must be this crazy secret that I don’t even know. I can’t comprehend.” But really, the answer is quite simple. I’m going to give you one last story just because I like to work in stories. So there’s Vince Lombardi. Have you heard of him?

Preston Pysh  24:43  

Oh, yeah.

Andrew Sather  24:44  

Every time there’s a Super Bowl, they’re holding Vince Lombardi up. He was such a great coach back in the day that they named the championship trophy after him. He had a really great team one year, and they went to the playoffs. They were expected to win it all, heavy favorites, but they got just absolutely destroyed. It was completely a letdown. He was very embarrassed.

The next year at training camp — on the very first day of training camp — he made a speech to all the players and he said, “We’re going to get down to the fundamentals. We’re going to learn every single fundamental. If you don’t understand the fundamentals, you have no choice. We’re going to go through each little one.” 

So, the very first day, they just practice tackling, the sort of stuff that you learned in peewee football as a little kid. And they went through every single fundamental to the point where the players were getting annoyed and they would make fun of the coach like, “Oh, stop, coach, you’re going way too fast for us.” But they meticulously went through, and this is how they did their training camp. Sure enough, that team went on to win the Super Bowl. They won multiple Super Bowls.

I think he had like five championships or something like that. And now, the trophy is named after him. So, what I’m really stressing with everything, with the value trap indicator, is let’s learn the fundamentals.

The number one way that you can measure if a company is successful or not, is if it is making a profit. The number one goal of a company is to turn a profit. So if it’s not able to do that… I don’t care if you call it loss leader. I don’t care if you think there’s going to be a comeback. I’m telling you right now: I analyze every single bankruptcy in the past 21st century, whatever we’ve seen up to now. 

The number one thing that most companies had in common was that they had negative earnings. So this is a huge red flag. If you’re going to invest in a company that has negative earnings, you’re gambling with your money. You’re taking a big chance. Yes, there’s the chance that they do recover, but a lot of times these companies don’t. When they’re saying that they are bleeding cash and they’re in the red, they are warning you that there’s trouble on the homefront. So you need to be careful of those situations.

The second one, we kind of already touched on. That’s the debt-to-equity with Lehman Brothers. When an individual person is having trouble financially, what finally takes him to bankruptcy court in the personal finance world is too much debt, too much leverage. It’s the exact same thing with companies. 

A company with too much debt is really towing the line. They’re really hoping that nothing bad happens. And so for a bull market, which may last 5, 6, 7 years. Things can be perfectly fine and they can have great profitability. Oftentimes, this leverage leads to more profitability because they’re able to maximize their profits and they’re able to do things that companies that don’t lever up aren’t able to do. But it does catch up with them. A lot of these companies do end up bankrupt because of too much debt. So you want to look out for negative earnings, and you want to look out for debt-to-equity.

Preston Pysh  27:48  

Stig, go ahead.

Stig Brodersen  27:49  

Andrew, I just want to say it was a fantastic point. Because we hear all these stories about how one investor was able to find a company that was rebounding. Everyone thought it would go broke, but then it just skyrocketed. The share price just skyrocketed. But basically, these companies that have too much debt and have negative earnings, they’re just too hard to figure out. I mean, even if you spend countless hours — at least, in my opinion — it’s just too hard to figure out whether or not they will be profitable over time.

Preston Pysh  28:24  

Yeah, it’s a probability thing. So you can have success by picking one of these companies that has bad earnings for multiple years. But the problem is your probability drastically decreases. You’re down in the less than 5% range, then it’s going to come back and you’re going to have a lot of success with it. So, I think that’s the thing that a lot of people lose sight of. You can invest and you can have success, but you’re making it very hard for yourself. One other thing and I’m going to throw it over to Andrew because I see he has a follow up. 

When you’re talking about earnings, that’s the lifeblood of the company itself. Think of it almost blood flowing through your body. Without that flow of the blood, you’re not going to live much longer. That’s where a company has to be profitable, because that’s what’s generating their ability to grow and to sustain their operations. Go ahead, Andrew.

Andrew Sather  29:13  

I was just going to say, when I was talking about Atlantic Power and the blog post I wrote about them, if you were looking at the stock screeners, they showed positive earnings for that time period because a lot of these stock screeners will update quarterly. But just because you have one quarter that’s profitable, it doesn’t mean you’re profitable over the year. So, I want to make sure you’re looking at yearly earnings. I know Ben Graham has said he looks at yearly earnings — he looks at even three or five-year averages. 

Whatever it is, you want to look at the annual report because that’s like the thesis that we’re all basing our evaluations on. And so, if you see a company might look profitable in the quarterly earnings, but if they’re not profitable in the annual earnings, then that’s something you need to consider. That was the case with Atlanta Power. They had negative earnings in the annual report, but positive earnings in their quarterly report. And sure enough, their stock tanked.

Stig Brodersen  30:11  

Okay, Andrew. For sure, I think it’s really interesting to hear about value traps. If you would like to give any recommendation —  books or resources — to our audience, what should that be? And as a continuation of that, I would also like to hear if you have any investors that you have heavily modeled your approach after?

Andrew Sather  30:33  

Yeah, that’s a good question as well. I would say, there’s the obvious books. There’s Intelligent Investor, some of Warren Buffett’s books — everybody knows about those. One that I really liked that helped me during this process was James O’Shaughnessy’s What Works on Wall Street. I know there’s a lot of people who don’t like him because he went through a time where he was very popular in Wall Street. Everyone used his ideas, and then suddenly, his ideas were not profitable anymore. Yes, that did happen. Yes, his back tests don’t work as well as they did before. 

But the information he presents in the book, and the lessons you can learn about why certain metrics and why certain evaluations are important, is really a great thing to look at. So, I think that’s one book that people should check out if they’re interested in this topic. Of course, you have my book too which you can check out — Value Trap Indicator — where I look at the 30 biggest bankruptcies. We break down what the Value Trap Indicator means, and we break down what were the similarities between these bankruptcies.

To answer the second part of your question, I actually did not model it based on one investor. I think what makes this indicator so different from everything else you see on Wall Street and with the value investing community and everything, is it’s unique and it looks at the big picture. What’s the big picture?

Let’s not get so focused on little optimizations and little details. It’s really easy to get stuck in that rabbit hole. Instead, what’s the big picture? What are these financial statements telling me? What’s the picture that they’re painting? What’s the overall picture of the company? Let’s use that to profit by limiting your drawdowns, limiting how much you lose on a position. That’s really how you outperform, if you want to outperform the market and even help boost your returns.

Preston Pysh  32:35  

I love that point, personally. Stig and I interact a lot with some of the people on our forum, and that’s the common thing that you see. A lot of people are just so quickly pulled into the weeds of investing, and they focus on things that are not big picture. I think for somebody who’s starting out, I think that is some fantastic advice, Andrew. Start really big picture. Understand what the profit of a company is. Understand what the debt of a company is. Understand how could the company potentially fail, which is your value trap indicator discussion. 

When you start with those really big chunks — think of it like you’re almost sculpting something — you’ve got to first knock off the big chunks whenever you’re sculpting something. Then, you slowly fine tune what it is that you’re trying to create. I think that’s what people that are new to investing really need to do. They’ve got to knock those big chunks off and understand the really big picture first. Then, eventually, mold themselves down so that they understand the finer elements of investing. So, really great point. I love that.

Andrew, if anyone wants to find you or learn more about you… I also want to throw it out there, Andrew is being very generous. He briefly mentioned that he’s writing a new book, and the book is going to be coming out soon. It’s not released yet. He’ll tell you what the street date is. But he’s also going to throw in a special thing for all of our listeners. So, Andrew, go ahead and tell people about your book.

Andrew Sather  34:01  

Thanks, Preston. The book is called Value Trap Indicator: Examining the Biggest Bankruptcies of the 21st Century to Formulate a Proven Buy Low, Sell High Approach. It’s everything we talked about today. It comes out on April 2. I’m going to open up an early release for your listeners, because I know this is coming out next week. And what I’m going to do is give you guys a special promo. 

You can get 25% off on the checkout if you put in the promo code “TIP” for The Investor’s Podcast. So, not only will you get first access to the book, which I haven’t even released to the public or my subscribers yet, but you also get this special discount. So, you can find that at valuetrapindicator.com. It will send you right to the landing page and you can find out more information about the book. And then, “TIP” for the promo code.

Preston Pysh  34:50  

Perfect. We’ll have a link in our show notes, as well, if you pull up our show notes. We have a link at the bottom for you guys to go ahead and check out Andrew’s book. That was awesome! Really excited to have you on, Andrew. The information that you’re imparting to our audience is very useful and valuable for them. I think that it’s a great fit, so thanks for coming on the show. We really appreciate it. That’s all we got, Andrew.

Andrew Sather  35:14  

Hey, thank you, Preston. Thank you, Stig. I had a great time, and thanks for letting me ramble today.

Preston Pysh  35:19  

All right, so this is the time in the show where we go to a question from a member of our audience. And this question comes from Eli Quanticos, and here’s his question.

Eli Quanticos  35:28  

Hi, Preston and Stig. Greetings from the UK! I just wanted to start off by thanking you both for providing all this invaluable information on your podcasts and on the Buffett’s Books website. My question has to do with a comment Preston made in his recent video, expressing his concerns about the health of the economy and what we might expect in the next couple of years. 

If I decided to cash out for my current investments, what do I do with the cash until the right buying opportunity reappears? Do I just hold on to the cash, or are there any other short term low-risk instruments that I can use? Many thanks, Eli.

Preston Pysh  36:07  

All right, Eli. So that’s the magic question here. I think for anybody that can answer that one, and look back in the next five years and see how they performed, I think that is going to be the true test of how good you are. But to tell you a definitive path of what the right solution is, that is really difficult to do.

I think that a lot of people get in a position where they know that there’s a crash that could potentially happen in the next year or two, they start moving into a cash position, and they feel like they’ve got to be doing something. And that’s when a true test of your patience kind of comes out. 

I think for most people, they’ll sit there for maybe a month or two and say, “I can’t do this. I can’t keep holding cash. I’ve got to put it into something.” So then, maybe they enter back into the stock market or they enter back into something because they feel like they’re doing nothing and that they’re falling behind.

But I’ll tell you: I think that your patience is probably the most important thing — the most important asset — that you’re going to possess during the next year or two until you see some major changes in the market. 

Now, what can you do with your money in the meantime? I think the key here is if you do invest your money, it needs to be something that is going to protect your principal, so that you keep that principal in place. 

And here’s the key: It’s got to be able to quickly be turned back into cash or be liquid. That’s the key because that’s going to give you the ability to enter back into the market and to go back and buy stocks whenever that opportunity persists. The thing that’s going to give you that liquidity is cash. You’re going to have no problems being able to transfer that into what you want.

Another option is bonds. Now, when you invest in an individual bond, you might be handicapped in the ability that you want to try to resell it at the right time. There might not be a real high demand for that bond that you’re trying to sell. So you might run into a liquidity issue. Now, if you’re investing in some type of bond index, you’re going to be able to liquidate that a lot faster.

Now, here’s my word of caution for anybody that’s looking at a bond as an investment during these next coming years: With a bond — especially with the interest rates the way that they are (which they’re at all time lows) — if interest rates creep up even in the smallest amount, the value of that bond index or individual bond itself is going to decrease in value. That’s where your risk really lies with owning a bond. 

So, the key is… if you do invest in a bond index, which is what I would recommend because you can liquidate it a lot faster, I would recommend that the duration of that bond is very small — something less than five years. Because the smaller the duration on the bond, the less that it’s going to be impacted with the change in interest rates. That’s the key point if you do move into bonds. But Stig, go ahead. Let’s hear your opinion.

Stig Brodersen  39:08  

Yeah. So Eli, I think this is a really tricky question. As Preston was saying, I don’t think that anyone really knows the answer to that one. You have to remember that this situation is very different from how it was in 2007 and 2008. I also think that Preston mentioned that. 

Back then, the interest rates were like 5% —  at least, if it was for long term bonds. You could put your money into bonds. And since the Fed has the opportunity to decrease the interest rate, you would actually make a profit. You would not only protect your principal, but also make a profit on bonds back then. The situation is very different today. As Preston was saying before, you really can’t make any profit on the FedLoan interest rate, which will make your bonds more valuable. So, what to do?

You know, I’ve been going back and forth on this, and I kind of agree with Preston in terms of cash. It might not be the best, but perhaps it’s the least bad option to some extent. One reason is that inflation is not really high at the moment. We’re almost close to deflation. So it’s not like your cash could lose a lot of value. But then, you will probably hear people saying, “Could we at least protect against inflation?” And I think you can. TIPS — that would be one idea. That would simply be a bond that defaults inflation.

You would probably hear other people talk about gold. Now, we can probably have a whole, long podcast just about gold. I’m sure that if you look at gold, you can see that they follow inflation, at least in the long run. But I think what I’m really cautious about at the moment is the volatility. So as Preston was saying before, you really need access to the cash really, really fast. 

And if you see a crash, you have no clue which direction the gold price will go. It might increase 20% or decrease by 20%. But if your goal is really to protect your principal, I would not go into something that has volatility. I think if you see a crash, then you can really make a high profit. You shouldn’t be thinking about making 1 or 2% return in the meantime. That’s really not where the profit is made.

Preston Pysh  41:26  

I’ve got a point that I want to add because Stig’s exactly right. This is much different than 2007 to 2008, simply because interest rates are different than where they’re at. And so as we look to the next crash… Whenever that happens, like we said, we don’t know. We think it’s going to be in a year or two years, but we really don’t know. But when that happens, I do know that the Federal Reserve is going to have to do something to stimulate the economy. Them lowering interest rates isn’t an option because it’s hard. It’s zero.

So, where they’re going to have to induce and to spark the economy is they’re going to have to print more money. They’re going to have to do more quantitative easing. And the difference between this time and that time is… On the last one, they changed the reserve ratio in order to offset that printing of more money. This time, they can’t really change the reserve ratio. So what I think you’re going to see is an inflation in the currency. How much? It’s really kind of hard to say. 

But whenever the market does crash, I think that’s going to be a very short window where a cash position is advantageous just because of the threat of inflation. Because that’s the only way the Fed’s going to be able to get out of it. I don’t think that that’s going to happen necessarily immediately after the crash. 

But I think that it might happen within the year of the crash, where whenever they start printing more money through quantitative easing, that’s where you’ve got a concern with continuing to hold your cash position.

So then the next question is, where do you go after that? We’ll have many more conversations where we can get into that. But I think people need to be aware of that. You’ve got to realize that there’s a risk holding cash after the crash for a long period of time, because the instruments and the tools that the Fed has at their disposal to fix this is very limited. It’s not like the last crash. They have to start inflating the currency. And it really comes down to how much are they going to inflate it?

Fantastic question. I think that’s probably the hardest question we could possibly answer. We really try to provide guidance to everyone out there. I really think everyone has to start thinking for themselves and really start making sure that you’re comfortable with the position that you’re in. The most important thing to me every night is to make sure I sleep well and to make sure that I’m not worrying about this kind of stuff. 

And I think for where we’re at right now, if you’re trying to protect your principal — whether you keep that in cash or you keep that in a low duration bond or something like that — I think that’s going to help you achieve that goal and also to make sure that you don’t get hurt or harmed by this potentially brewing economic issue that we’re facing.

It’s a long response, but we really like the question though. We’d really like to thank Andrew for coming on the show. He gave a fantastic interview. And I think that he brings up some really important things that people need to be thinking about as we go into this high valuation in the market and these interesting times, I guess.

And so Eli, we’re going to send you a free signed copy of our book, The Warren Buffett Accounting Book. We just really appreciate your question. For anybody else out there that has a question, make sure that you go to asktheinvestors.com. You can record your question there. We’ll potentially play it on the air and send you a free book. We really appreciate everybody joining us this week. Thank you so much for being in our audience. We really do value everyone’s input, and it’s really fun interacting with everybody on our forum and all the other places. We’ll see everybody next week.

One of the things that Stig and I are very strict about is not endorsing any kind of service or product that we don’t personally use ourselves. So with that said, we give our full endorsement of our sponsor’s content, realvisiontv.com. Real Vision is a site that Stig and I personally use ourselves, and it has had a profound impact on the way that we view the financial markets.

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Outro  46:37  

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