Hari Ramachandra  09:59

I have one thought to share when I was listening to your description. One thing was sure that this is way out of my circle of competence.

Preston Pysh  10:10

It’s probably out of mine too. So, don’t worry.

Hari Ramachandra  10:12

Yeah. So, I think three-fourths of what you said just went on top of my head. So, I would just watch and educate myself, but I’m going to stay away.

Calin Yablonski  10:22

Yeah, and I would say the exact same thing. I mean, I’ve talked a little bit about previous Mastermind meetings and groups about hedging the Canadian Dollar relative to the US dollar. So, I’ve done a little bit of that and investigated it a little bit. But in terms of leveraging myself and potentially buying real estate to effectively short a currency, it’s not something that I would have a lot of experience in.

Preston Pysh  10:43

Yeah, it’s very difficult. And I think that Stig had a great description of trying to do two things at once. So, hey, Hari, go ahead and go with the next question. I want to hear what you got.

Hari Ramachandra  10:52

Sure, just to talk about the markets in general. We know that a lot of countries are facing a slowdown in their markets, whether it is China or Japan, and the US is kind of relatively doing well, it’s like a good house in a bad neighborhood. However, there have been recent discussions all around about are we in a bubble or the stock market and the US getting overheated. This brings to the point that Mohnish Pabrai in his annual shareholders’ meeting said, he doesn’t think we are in a bubble. However, he said he thinks we might be revisiting Nifty 50.

For those who are not familiar with Nifty 50, it refers to the 50 popular large-cap stocks on the New York Stock Exchange in the 1960s and 70s. And they were regarded as solid buy and hold growth stocks. Nifty 50 was credited for propelling the bull markets in the 1970s. Most of them were solid performers and these companies are still around. And these are companies like McDonald’s or Disney.

However, there were a few technology stocks in that Nifty 50 like Polaroid, Eastman Kodak, or Digital. You know, they’re not here anymore. So, not all of them are great. However, the B valuation for them was high, they were in the 90s. And as we enter the 1980s, the valuations for them drastically fell. And a lot of people lost money, and Pabrai kind of enough saw some similarities in today’s market where there are some darlings of the stock market or highly valued companies in the technology sector. And there are many other companies which are decent but are totally ignored by the market. So, he said there is some imbalance in the market. I wanted to get your thoughts. What do you think?

James Meirowsky  12:56

I don’t know. There was an article in Forbes back in November and it talked about the S&P 500, that there were basically five companies kind of carrying the S&P 500. It was like Amazon, Alphabet, Microsoft, Facebook, GE. And it basically stated something along the lines of without those companies, the S&P 500 would be at a negative by like 2.5% or somewhere around that number. So, I don’t know if that kind of highlights what you’re talking about, Hari.

Hari Ramachandra  13:24

Yes, I think that’s a good point. In fact, Amazon, Alphabet, or even Facebook, and many other technology companies are valued at a very high PE today. And some of them don’t even show earnings based on gap reporting. They have adjusted EBIT earnings, and even then they are valued in terms of PE multiples of more than 50 or 60, which kind of is very similar to the Nifty 50 era.

So it’s a great study to learn from what happened and what kind of mindset and psychology played into the higher valuations then. So, all of them, as you mentioned, start with a grain of truth. That, yes, the Nifty 50 were a great buy and hold stocks, and they were growth stocks as well, they were growing at a very healthy pace. But when you overvalue them, and when you pay high prices, they no longer are as great as an investment. So, that was the point, I guess overall, I was trying to make. Even today Amazon is a great company, but at some price, it will start looking to be a mediocre investment.

Preston Pysh  14:39

So, Hari, I want to throw out there because I’ve studied the PE ratios over the last 75 years and I’ll be honest with you. From the 1960s to 1980 timeframe, somewhere in there, I don’t remember the PE ratios ever getting to the levels that they’re at today, assuming that you’re using like a Shiller PE ratio.

Right now, where we are at, it’s much higher than we ever had back then. Now, I think your point is more that there were a few companies that had multiples. They were traded at multiples, similar to the ones we’re seeing today. But I would disagree with Pabrai, which means I’m probably wrong. But I would disagree with Pabrai and say that I think that we are in a much worse position today because I think you have more companies that are being traded at that multiple. And I think it’s totally a function of the interest rates.

So you go back to that period. Interest rates in the 1970s, they were very high. And right now where we’re at, we’re polarizing rates to zero. So, when you do that, and you look at the corresponding market price that is associated with those interest rates, it’s very hard to get a high market price on equities when you got interest rates over 10%. It’s just a fact because they’re totally correlated to each other. There’s this back and forth as this flow of capital between fixed income and equities that occurs.

So when you drop rates down to zero, you’re going to see those prices and equity shoot up because people were doing that comparison. People were saying, “Let’s go back to 2008-2009. It’s a perfect example.” If you go back then, where were PEs at? A PE of 10? So that means you’re going to get a 10% return if you invest at that level, assuming that their earnings remain constant.

As an investor, that’s a no brainer decision for somebody that’s allocating a lot of capital. They’re like, “Hey, I could get a 10% return on equities. Or I could go to the fixed income side and get 2%.” Tou know, where are they going to go? Well, they’re going to start funneling all their money into equities. And so that’s why you saw the price and equities just build and build and build until these are coming between fixed income and equities or stocks. They’re coming at parity with each other. And so that’s why I think he’s wrong. I mean, I just do and I think that it’s a function of looking at the interest rates in this era versus that era. And I think that we’re very high.

Stig Brodersen  16:46

Yeah, I want to hear from James and Calin because you guys you know things about technology, as you heard in the beginning, compared to Preston and I. So, this might be within your circle of competence? So are you guys invested in technology stocks right now and why and why not?

Calin Yablonski  17:05

I tend to stay away from technology stocks, even though I work in technology. And maybe it’s a function of just seeing what the inner workings of the businesses look like. When I invest in companies, they tend to be standard traditional companies, so Berkshire Hathaway, or on the private side, in local businesses that I can either finance myself or purchase myself. But no, I tend to stay away from technology stocks like a plague.

James Meirowsky  17:32

Yeah, I can agree with what Calin said. I’m not in any of these companies. At the moment, I think technology companies are within my circle of competence, but I think that the way that they generate revenues is significantly different. So, yeah, I don’t currently invest in anything, but I’m also kind of a bear right now.

Preston Pysh  17:50

So Hari, I just want to ask you a question because you’re out there in Silicon Valley. So, I think that you would have a better beat on this, but I’m reading articles. I’m looking at one right now from the Wall Street Journal, and the title is “Venture capitalist sounds alarm on startup investing.” And this is a very recent article, and there are tons of these articles out there through Bloomberg, Wall Street Journal, where they’re basically saying and you’re seeing billionaire saying it too, that out in Silicon Valley, there are unicorns is that is the term that they like to continue to use in the financial news. Another unicorn, another unicorn, and what they’re referring to is just these insane market prices and multiples that people are paying for top-line revenue with for a company that’s not even profitable.

So the first question I got for you. Are you seeing some of that starting to dry up or tighten out there in Silicon Valley? And I guess I’m just curious if you’re hearing any like horror stories of how much harder it is for startups to basically capture money from venture capitalists out there.

Hari Ramachandra  18:48

That’s a great question, Preston. And that is something that is on my mind from the past couple of months. And you brought up a very good point in Silicon Valley today. Unicorns are like ponies, you can find them everywhere. So, they’re no longer unicorns. And the valuations are also reaching published territory like Uber today is around $63 to $65 billion valuations, even before it has even gone public.

However, people are sounding the alarm and you’re right. And now I see that the Valley is split into two camps. You might have heard about the famous argument between Mark Cuban and Marc Andreessen on their blogs about the bubble in the valley. And how Mark Cuban thought that the private equity that is a bubble, and Marc Andreessen argued that he doesn’t think so. In fact, he thinks that it is still fairly valued or maybe undervalued.

So there is definitely a kind of ideological argument going on. But what I see on the ground is that reality is slowly sinking in. For a couple of reasons. Number one, when some of these unicorns, like *inaudible, went public, they had to down value their initial public offering compared to how they were valued in private equity. So, there is definitely a bubble in private equity. So, that’s those are the signs.

And also, another thing I’m seeing is there is a slowdown, even though it’s very slight in the real estate market in the valley. So, the bidding wars have reduced. The number of bids that houses on sale used to get is slowly coming down. So, all these indicators on the ground, that there is some cooling off going on, whether it will be gradual, or the bubble burst, all of a sudden, it’s hard to say.

Preston Pysh  20:44

So I want to bring up a topic that I am paying a lot of attention to and that I’m putting money into. And I think this is going to surprise a lot of people and I’m going to throw this idea out there. In fact, I just sent this out in the newsletter last night to all of our listeners for the people who are subscribed to our newsletter. I send out how I’m seeing the current market. Sometimes, I’ll even throw out some of the stock picks that I’m purchasing. Last night I did that. And it’s a very odd one and not one that I guess I would have seen myself doing a few years back. And that’s because it was a short position. And for anybody out there, I’m not necessarily recommending it for the audience. I’m just saying that this is something that I’m doing, and I want to talk about it. And if it ends up being a mistake, I want to talk about it on the show so everyone can learn through my mistake, potentially.

So here’s the idea. I think that the high yield bond market is a disaster. I think that this thing is just getting warmed up. And I think it’s going to be disastrous, in my personal opinion. I’m sure you could find some people out there that might argue in the opposite direction. But what I can see right now you have a major out of balance, supply, and demand for buying and selling what’s happening in this market right now. I’d say 2011 through… even up to 2014, you had tons of people buying into this market because they were chasing yield. You couldn’t find a yield anywhere.

So what happened was you had a lot of people that go into the high yield bond market because they’re able to pull out a 7% or 8% return by being in it. And now you’re starting to see a lot of people sell out of that market because you’re starting to see the defaults go up, which… Stig and I have been talking about defaults increasing in the industry, across the board. I mean, we were talking more specifically in the energy sector, but just across the board, we’ve been saying that these defaults are going to continue to go up, and they have. So, that continues to happen. You’re seeing more and more people say, “Hey, you know what, I don’t want to be that guy that’s holding on to this high yield bond.” And when we say high yield bond, junk bond, same thing. It’s a borrower with a very good chance of default. That’s what we’re talking about here.

So you’re seeing a lot of people say, “I don’t want to hold this stuff.” Well, here’s the impact of that. So, when you have an influx of people that are selling out of the high yield bond market, what happens is that pushes up the yield. So, as yield goes higher, and now these companies that are defaulting need to borrow again, guess what? They’re not getting the bonds at 7%. Now they’ve got to go and they’ve got to issue these things at 10% or 13%, or where they’re at right now, which is 17%.

23:18

And so my personal opinion, I might be completely wrong. But my personal opinion is one of the leading indicators that you’ve basically hit the top of a credit expansion cycle, is when you start to see the high yield bonds or the junk bonds start to the yield on those start to take off and you see a lot of people selling out of them. That’s what we’re seeing right now.

In fact, let me pull up my chart here. So, I saw I quote this correctly. Okay. So, if we go back just a couple months, you’ve seen the high yield go from around the 14% level clear up over 17% with just in the last month alone. Now for some context because my next question would immediately be how high did high yields go during the last crash or the last tightening? And so just to put this in context, it’s at 17% right now. During the last downturn in 2008-2009, it got as high as like 45% in high yield. So, that kind of gives you an idea of how much more this has to go.

So my opinion, we’re moving in that direction, we’re starting to see the tightening of the overall seven, the short term business cycle credit cycle starting to contract. I think that the high yield bond market is the leading indicator of that. And so for me, I’m comfortable, very comfortable stepping into a short position into the high yield bond market. I’ve done that through a ticker called SJB. If all that sounds like Greek, all that stuff, I’m saying do not go out and buy SJB. This is something that you need to understand yourself. If it makes total perfect sense to you, then I tell you that hey, put the play on, do it. Have fun, see what happens. But I want to continue to talk about this position because it’s a short position. It’s not something that I’ve done in the past. So, with all that said, I want to open it up to the group and see if you guys have any comments: if you think it’s a bad idea if you think it’s a good idea, or you have no comment. I think we’ll just go around the horn and see what people say.

Stig Brodersen  25:11

Well, you might be right because right now we’re seeing a high market. And you probably also see that there’s a lot of credit, as you’re saying that’s contracting and you have an increasing interest rate or at least we assume that you will have a hike in interest rate. So, this is recorded on December 13. So, this is before the Fed meeting. So, we can be completely wrong about that, obviously, but it would make sense if you would see more sellers and buyers in this market. I think one of the reasons why I’m not doing it is that I don’t know when I want to close my position. I think that’s important for me to have an idea about it. So, like, I would like to hear this from James, Calin, and Hari, but I would also like to know from you afterward, Preston. When do you intend to close the position or what your thoughts are on that?

Preston Pysh  26:03

Okay, so we’ll go around the horn and then I’ll answer Stig’s question.

Hari Ramachandra  26:07

I have a question for you. And that is about the reason why the interest rates in the junk bond or the yields in the junk bond go high. Why are people exiting out of junk bonds? And if they exit out of junk bond, where are they going? What do you think is the reason for them to exit out of their positions in the junk bonds? Do they fear that the company’s underlying companies are not going to farewell? Or is it more a macroeconomic position?

Preston Pysh  26:35

No, I’m basing it on the fact and this is my opinion, I could be completely wrong about why people were doing it. But the reason I think that you’re seeing a lot of people sell out of it is that you’re seeing the defaults increase and you’re starting to see that pick up and accelerate slightly. That’s why I think people are selling out of the position and I think where they’re funneling that money is I think they’re keeping it in fixed income. But they’re putting it into maybe federal treasuries, something that is totally protected, that there’s no risk of default on. I think that’s where it’s going. I don’t think that they would necessarily be taking that and putting it in equities. I could be wrong, but I would say they’re probably chasing something that’s a lot less risky in the fixed income side.

Calin Yablonski  27:13

So I would say that since I take all of my stock investing advice from Stig and Preston that it’s a brilliant idea.

James Meirowsky  27:22

But you know, for me, I’ve never been a proponent of shorting. You’re betting against a company, you’re betting against a stock, you’re betting against a bond. And for me, that’s it’s always been an uncomfortable position to take, just in terms of how I approach investing. So, for me, I’m much more prone to invest in a small business or something within my own company.

Preston Pysh  27:44

Before James goes, I want to comment on Calin’s response because I like what you just said. Anyone that’s gone through the videos that I put up on Buffett’s books, I highly promote people to invest and not to speculate. But you know, I have to admit, like the position is quite speculative because what is it that I’m investing in? Am I investing in a business? No, I’m not. Am I investing in giving some people lending money so that they can be productive with it? No, I’m not doing that either. In fact, I’m doing the opposite of that. And so is that right? I think you could get into a big long discussion on that. Is this trading instead of investing? I think you could maybe say it is trading.

Preston Pysh  28:24

I’m just wrestling with the idea myself, to be quite honest with you, but I want to be fully open and honest with the community and tell them what I’m doing. But whenever I look at this, from my vantage point, I say, “Hey, there’s going to be more defaults. The dollar is getting stronger, the Feds are potentially going to raise rates, which is only going to amplify this.” And so what I’m putting a position on is that I think defaults are going to continue to increase which is going to result in more selling and if that’s a position that I could make money on, I guess, I’m exercising that and I’m going after it.

So far, and I think this is good for context, is I got into this position, kind of near the beginning of December. Probably like December 5th. I want to say the position is up like 5% or 10%, from where I bought in during that time frame already. And so, I’ll continue to update people on this every other episode or whatever as things develop, and we’ll see what happens.

Stig Brodersen  29:14

So Preston, when do you want to close this position? So you’re saying, okay, it’s up 5% or 10%. So, how do you evaluate the position? Is it like, “Hey, I want that to go up by say, 50%?” Or is it like, “What’s the interest?” Or how do you evaluate that?

Preston Pysh  29:32

So my exit strategy is pretty simple. And it’s based on historical results. And that has nothing to do with saying that this is how it’s going to play out next time. But when you look at those defaults from the last 2007, which that might be more dramatic than this tightening cycle or whatnot. But when you look at… when it peaked, when you got a 47% yield in high yield bonds, that happened right around the time where you were at a stock market bottom.

So my other opinion would be that I might see similar yields in that market that would be similar to where it was at last time. So, if it’s at 17% right now, and last time it went to 47%, I would say there’s a lot of margins left for that to continue to turn into even a better position than where it’s already at. So, that’s kind of how I’m basing it.

I’m also looking at the volume on the equity market when I think whenever that volume on the equity market would spike, and you’re seeing a lot of people start to buy back into the equity market, that might be a good spot for me to kind of move out of the position. So, for me, it’s kind of like a long play because I don’t know when the market is going to meltdown. I have no idea when that’s going to happen. I mean, it could be a year from now, I don’t know. But I do feel that based on all the charts I’m looking at and all the things I’ve been researching, I think that we are in a position right now where we are starting to contract and tighten the money supply, which means I think defaults are going to go up. The first place that’s going to happen is in the high yield market. And that’s why I think it’s a good play, but I don’t plan on moving out of it anytime soon. I can tell you that it’s not like I’m going to sell out of this two weeks from now.

Calin Yablonski  31:05

Okay, so the question that I wanted to ask you today and the topic I wanted to discuss is nano-cap stocks. So, these are stocks that would typically be classified or not even stock sorry, but private equities or private companies. They are typically classified as companies that have somewhere between $2 and $20 million in annual revenue.

Now, what was interesting is that I read a report that was published a few years ago, that said by 2022 in Canada, that a lot of the baby boomer businesses, which will contribute then about $3.7 trillion to the Canadian economy, these businesses will be looking to trade hands. And in total, there were about 550,000 of them.

So the interesting thing is that they’re discussing what’s called the nanogap, the fact that there’s not enough private equity and people purchasing these companies available to accommodate for about $3.7 trillion worth of businesses that are going to be on the market. And so it just, it seemed like an opportunity. And I was hoping to collect the feedback from the group just as to what your thoughts are on these smaller businesses, knowing that they potentially tend to be higher risk, but they also tend to trade at a relatively low PE ratio.

Stig Brodersen  32:21

This is the something that Calin and I have been discussing outside of the forum and Mastermind meetings. We were meeting up in Canada and like six months ago, and doing all the maple syrup tours and the beautiful, beautiful landscape of Canada. And then we discuss it with a lot of business. And I think the thing I remembered most from the trip was this discussion we had about this gap, as you’re talking about this nanogap. And I have to say, if I could figure out how to manage these companies, if I can figure out somewhere I could put someone trust to tremendous these companies, I think this might be one of the biggest opportunities out there right now because what Calin said that the PEs of this company was low, but we talking about PEs of one 1.5 or something like that. Is that correct, Calin?

Calin Yablonski  33:10

Yeah. So, I’m a partner in a waste management company here in Calgary. And other comparable companies in the industry, I’ve seen them trade at or below the price of their assets. And when I say trade, I should clarify they are private companies that have been listed for sale at or below the price of their assets, not taking into consideration their cash flow, which for a lot of small businesses can be quite substantial, even though they might only be doing $5 million in annual revenue.

Preston Pysh  33:39

So Calin, I got a question about that what you just described because to me, that sounds like that would be a short-term situation based on the troubles and the difficulties that they’re having in the economy up there in Calgary right now. So, is that a true statement? Or is this something that you think has been kind of persistent even in a good or bad economy up there?

Calin Yablonski  33:57

So I’ve seen these opportunities probably over. the last 12 to 24 months, I don’t believe that it has to do specifically with the economy right now. In fact, a lot of the companies that I’m talking about are companies that have been for sale or listed in the United States. It tends to be more of an issue with succession planning and finding people who are willing to purchase these companies knowing that in most cases, they’re owner-operators. So, somebody has to come in and manage a team, manage staff, manage the accounting and billing, and all the other things that go along with running a small business.

Preston Pysh  34:29

So would you say that basically, these people have created these companies, but what they’ve done is just create a job for themselves, and as you remove that person who’s basically running it, managing it and giving themselves a salary, if you have to replace that person, and it wouldn’t be yourself because you’re just going to sit there as the owner, you’re going to hire somebody into that role… Maybe the earnings at the bottom of that, the net income at the bottom of that is kind of minuscule and not worth the risk. Would you say that that’s a true statement because that’s what I would expect?

Calin Yablonski  34:58

Yeah, it’s very close in some situations too if you were to replace the owner of the company, is the cash flow going to be substantial enough to warrant your investment of time.

Preston Pysh  35:07

So I think that’s what you got to ask yourself because if you start skimping on that salary, so let’s say you don’t get somebody strong to step in and run this small business, and you… because that’s your margin is how much you pay him versus you pay some guy who’s not trustworthy. Whatever that delta is, that’s your margin that you’re playing with. And so do you want the headaches with a bigger margin? Or do you pay somebody who can manage it, and you don’t make all that much money and you’re potentially assuming the risk if somebody got hurt while they’re in the john or whatever. You’re assuming risk there. Do you know what I mean? So, I think it’d be a case by case kind of thing. But that would be kind of at the heart of the calculation as you’re trying to figure out if it’d be worth your time.

Stig Brodersen  35:51

I think the potential of what you described here, Calin, I think that’s huge. I think it’s very difficult. So, one thing is the whole management system as we discussed. The other thing is how do you read the financial statements? So I’m not saying that the financial statements are necessarily manipulated, but they are regulated differently. So, the way that you would regulate the financial statements for a listed company and *inaudible listed company is very different than what you see whenever they might send you the financial statements. And it might be tempting to say, “Okay, so this company is making $600,000 the bottom. I can buy that for $700,000. Wow, I get a huge return.”

But there was just so many things that you need to include in that calculation, I think that would be hard. I also think that if you are capable of doing that, I think your return could be huge. I think you can make a lot more than you can do in the stock market because as you say, this is a supply and demand issue. Say you’re 68 years old, your son or daughter, perhaps you don’t have any kids, you don’t want to continue with your waste management company. So, what do you do? Like who’s going to run that company? You might not want to sell to your competitor in the city. You might be the only one in town. Who has the expertise and who has $700,000 in cash to buy that company? I think that that’s the tricky thing.

Preston Pysh  37:11

Yeah, Stig, you hit a home run with that because, well, you got to also think about what’s the market size for that specific location. It’s not an online business. So, your market size isn’t the world, you’re kind of stuck to your local area of how many people have  500k or $2 million to buy these tangible assets. Your market size is four people, you know what I mean? So that’s going to drive the price down and you’re going to have a low multiple which is a great thing if you’re a buyer in the market.

Stig Brodersen  37:39

I think the market cap that you talk about, Calin, I think that’s interesting because say something like $2 million. Like there are very, very few people that have $2 million. And if you do have that, you would usually buy something bigger, right? So if you are in like private equity or if you’re a bank. You know, if you’re a bank, $2 million is not that interesting because this is a case by case thing. You need to put the same energy in a 2 million dollar project than you might do in say a $100 million. So, why would you care about $2 million, but there are very few private investors who have $2 million. And even then they have, they don’t know. And they’re not diversified enough by buying a waste management unit or whatnot when they could be in the stock market.

Preston Pysh  38:17

And something to say, on top of what Stig said, they’re not going to want to do something operationally. If you got $10 million, you don’t want to have to be dealing with the problems and the issues of running an operational subsidiary. So, that’s the other piece of it, too. But I mean, you’re young, you’re going to kill it. So, I say you have at it.

Stig Brodersen  38:37

I’m just thinking I might have all this knowledge about the stock bug, but that might yield 4%. And then you have someone like Calin because his knowledge is much more specific. He knows how to run a waste management company. And you know, he has the cash and he knows what he’s doing so, and that might yield 100% a year. That’s a lot more interesting to be Calin than to be Stig, I can tell you

Preston Pysh  38:58

And if anybody in Calgary types in waste management on Google, he’ll be the first result.

Calin Yablonski  39:05

Yeah, let’s hope so. Cool. Thanks for your comments, guys.

Hari Ramachandra  39:10

So Preston, and Stig, I had one question for Calin, and that is: are these companies usually service-oriented? Or do you find any of them have a product with captive customers?

Calin Yablonski  39:24

It’s a good question, Hari. The companies that I’ve looked at tend to be more service-based, locally service-based companies.

Hari Ramachandra  39:31

Yeah, I think that’s that was my concern, too because as Preston and Stig mentioned, if it is a service, then the owner-operator brings in a lot of contexts, connections, and talent, which might be the core value of the business that might be lost when he sells to another party.

Preston Pysh  39:49

Absolutely. That is very common.

Calin Yablonski  39:52

Yeah. That makes a lot of sense. Thanks, Hari.

Preston Pysh  39:55

Yeah, the IP is the knowhow of having the system and the protocol in place of how you manage it. All right, so I know Stig’s got a question for us. So, go ahead and fire away.

Stig Brodersen  40:05

Yes. So, last quarter, I’ve been looking into momentum investing. And momentum investing is very different from value investing. And I’m sure you guys know where what I’m talking about. But just to give you a brief explanation. So, with momentum investing, you would buy a stock say that the stock that had appreciated most in price in the previous three months. And then you would just buy into that, in the hope that it will continue to appreciate and you will continue to rebalance. And whenever a stock stops doing that, you will just rebalance that and replace it with a new one.

Stig Brodersen  40:39

So when I heard about this strategy, the first time I was like, “This is the stupidest investing strategy ever heard about.”

Preston Pysh  40:46

You just read my mind.

Stig Brodersen  40:49

I was like this technical analysis. It doesn’t make any sense. It was data mining, whatever. But then I was speaking to Toby, who unfortunately couldn’t be here today. He was like, “You know, Stig. I think momentum investing is something you should be open to. And I think that sometimes it might be even performing even better than value investing.” I was like, “If Toby things is an interesting idea, I’m not saying I will just go invest all of my whole portfolios into the strategy, but like if someone like Toby says that I should take a closer look at it, I should probably do so.” And it seems like I think the data I have is from 64 up to 2014. It seems like this strategy has outperformed the market more than value investing and that was something I was so surprised about. So, I would just like to hear your guys take on momentum investing. Is that something that you would consider buying into and why and why not?

Preston Pysh  41:46

You know, if Toby was here, I’d say that’s a great idea, Toby, but since he’s not here today, Toby, that’s a horrible idea.

Hari Ramachandra  41:55

So Stig I have a question. What is the average holding period of that strategy? And when you’re talking about performance, are you considering after-tax returns or before?

Stig Brodersen  42:07

Yeah, that’s a great question. So, you would rebalance every month. So, one thing that you need to be aware of is that you have to pay a lot of cost doing that, obviously. Probably the most efficient way to do this, but be using an ETF because then it’s more tax efficient. You don’t have to pay tax, whenever you’re balancing. You only have to pay tax if you sell your ETF. But it’s a great question, Hari. The numbers I’ve seen are that you should probably add between 2% and 3% in extra cost if you’re using a momentum strategy, but even so, it seems to be outperforming value investing, at least in the data I have been looking at. And I do want to say some of the data we’re looking at, they’re also selling a product, which is momentum investing, which is very surprising. But I just want your take on the strategy.

Preston Pysh  42:54

So I just want to walk through my thought process as I’d be going through this. So, let’s say I have a company that I like, that I think would be a great momentum pick. And let’s just call it company X. So, I buy this. And so the strategy is, is I buy it as it’s trending up, and I continue to hold it as it’s trending up. So, let’s just say it’s after the first week, it’s gone up, it’s up 10%. And then it has a 3% downturn. Is the trend dead at that point? Do I sell? Or do I buy more? Because the trend is going where?

I think that’s my question is like, how do you know when the trend is done? How do you know? I just don’t like it. For me, it doesn’t make a lot of sense. And I know people were going to say, “Well, you look at the 60-day moving average, the 90-day moving average and the 120. And when you start seeing them go inverted, the trend is dead.” And maybe that’s the strategy but for me, I know I’d be an emotional mess looking at something that I can’t take a long position in that is based on something that I expect a trend to go for a very long period. So, I don’t know. I want to hear what James has to say.

James Meirowsky  43:58

Yeah, tacking on to what Preston just said Stig is determining, I don’t know what your exit strategy is, but how automated is that strategy? And does that plan to alleviate or address Preston’s concern?

Stig Brodersen  44:11

Yeah. So, it’s automated. You don’t look at the company. You’re not looking at is there any competitive advantage anything. You look at whatever stock appreciated most over a given time. So, like one month, it might be stock X, and the next month, you will be stock Y. And you don’t look at the intrinsic value at all.

James Meirowsky  44:29

So as I understand it, you’re basically holding a basket of these momentum stocks for x period, right? So 30 days, and then you’re selling everything right? The good and the bad completely buying a fresh new batch.

Stig Brodersen  44:40

Yeah, exactly. And that’s also some of the things that I’m struggling with, that’s probably because I’m setting my ways about value investing, but I like the idea of buying $1 for 50 cents, right? So I would be buying say, Berkshire Hathaway, great competitive advantage. I will buy that cheap and I would say, “You know, it might be down 6% tomorrow, but I don’t care about that. It’s still undervalued. I know over time it will appreciate and converge to the intrinsic value.” And *another will say, a moat that I understand about this company. I think I just feel more comfortable about that. And I think that leads back to what Preston said before, like, how much stress can you handle? I think the problem I would have with momentum stocks is that I wouldn’t know what to own. Like, I would own a calculator. It might be a great calculator that I own, but I have no clue what it is that what’s in my portfolio. And I think to have a strategy, using a momentum strategy, I think I need to redefine my paradigm of investing.

James Meirowsky  45:40

I think you guys have Patrick O’Shaughnessy on the show not too long ago. And one of his major comments was saying that “Hey, whatever strategy you land on, you have to stick with it for not just a short period, but for years, to really, truly see it play out.” And then he was also talking I don’t remember what the ratio was.

Stig Brodersen  45:59

Yeah, it was 70% value *inaudible and momentum.

Calin Yablonski  46:02

Stig, Sorry, just a quick question. But what’s driving the momentum in these stocks? Is it publicity and PR associated with the stock? What’s pushing it higher over those 30 days?

Stig Brodersen  46:13

It’s that people feel comfortable about buying a stock that is increasing in price. And there is a new stock every month or bundle new stocks every month increase in price, and that’s what people like and you will just rebalance.

Preston Pysh  46:25

I just want to highlight to the audience that Stig has the biggest smirk on his face as he just said that.

Stig Brodersen  46:33

It’s just like I’m speaking to these brilliant people. James mentioned, Patrick O’Shaughnessy before, Toby Carlisle. I have spoken to Wes Gray about this, like three people I respect. Three people come from a background in hardcore value investing. So, I mean, it’s not your average Joe stock investor. These guys know what they’re talking about and all three of them say, “Stig, you should look into momentum investing and understand what is driving this and it might be something for you.” And I’m just inspired. I haven’t made a decision. I’m just inspired.

Preston Pysh  47:04

I do appreciate this conversation. So, I think this is a good conversation. And I think that Wes, Dr. Gray is an extremely intelligent person. And some of his research is fantastic. And same with Toby. These guys are, I mean, they’re brilliant. These guys are the leading guys in the industry as far as I’m concerned. But there’s something I want to highlight with this whole discussion that came out. I forget whom we were talking to. I think it was Patrick O’Shaughnessy .ho said this? He said that this strategy works best when you’re pretty much kind of at the top of the market cycle, and you’re seeing value not working so well. And that’s whenever you’re seeing this momentum strategy work well. But he said it works the worst when you’re coming out of that when you’re seeing it during the tightening phase and you’re seeing the value approach perform the best. That’s when you see momentum strategy working the best.

I think that that trigger between those two points in time almost happened instantaneously. Like that happens over like one week. So, if you’re implementing this strategy, you could get caught with your pants down and you’re just kind of screwed because now you’re going from the thing that’s giving you the best result to something that’s giving you the worst result. And it’s happening in such a short duration of time. So, that’s where I’m hesitant to just jump into this. But I do find it absolutely fascinating. I think that the backtesting would be something that I’d have to kind of see firsthand a whole lot more to see how they’re executing it. I got Wes’ new book, “The Do It Yourself Investor’s Guide” that he wrote, and I haven’t had a chance to read it yet, but I’ve been flipping through it. And I’ll tell you, I am so impressed with Wes Gray. That guy knows what he’s talking about. It’s phenomenal.

Stig Brodersen  48:36

Yeah. And what I think is interesting reading his book is that he’s saying, “Well, you might consider having a 50% value investing and 50% momentum stock.” Because as Preston is saying, one strategy is better when it’s bull and another strategy is better when it’s bear. And if you don’t know where you are, you can always just rebalance to 50% every now and then, and you’re done like again. So, you would argue that even though it might seem like you’re under a lot of stress, if you have momentum stocks, you might not be because you don’t think about it, you just rebalance to that 50% without thinking about where the market is going to go.

Preston Pysh  49:09

And you know, something that I think would be an interesting thing to research. So, he was talking about how sometimes this momentum strategy works better than value and vice versa. I bet you if you go back and you look at the credit cycle, and you would line up, look at an XY graph, I bet you 70% of the time, which is the number that he suggests that the use of value-based strategy, I bet you, when you look at that credit cycle, 70% of the time is in that window where you’ve got credit expanding and not contracting. You’ve got about 70% of that time is where that’s happening. That’s probably why the value works best there. Or the other 30% is where you’re going through that tightening phase in that contraction, and maybe that’s where you’re seeing the other strategy work better. I don’t know. I think it’d be something that’d be interesting to kind of dig into and see why he came up with those numbers.

Stig Brodersen  49:54

But I’m curious to hear… I haven’t heard from you Calin and Hari. So, like, I know that you are both into hardcore value investing. So, what do you think about momentum investing? And does it alter your opinion that someone like Toby, as you know, a member of Mastermind group, but also someone like Patrick O’Shaughnessy and Wes Gray, that they are too into value investing, but still think that momentum investing might be the way to go or at least a part of your portfolio?

Calin Yablonski  50:20

I think that anything that Toby says and recommends is something that you have to look at in more detail and consider because Toby like you have been saying, he’s one of the smartest guys that you can ever meet. Now, would I do it? I think that’s a different story altogether. It seems risky. It seems like it’s just tied almost directly to the psychology of the market then. And when you are relying entirely on the psychology of the market, I think that’s a risky strategy, just thinking about it logically.

Hari Ramachandra  50:50

That’s a great point, Calin. I agree with Calin as well as Preston here. I feel Toby is a very smart investor. However, his situation is different from mine. Toby or any other fund manager has to compete with other fund managers as well as index down to perform better than in index to produce that alpha. Whereas for me, as an individual investor, I’m competing with my bank account. So, I have an easy life compared to Toby. So, I don’t have to raise my stress levels to follow a certain methodology. I can stick to whatever works for me. So, I don’t know whether momentum investing is better than value investing. But I feel for me the unit of stress or rather than return on the unit of stress in value investing, the style I follow is much higher than if I would follow momentum investing. So, based on that, I would lean towards value investing rather than momentum.

Preston Pysh  51:51

Okay, guys, so really, that completes our Mastermind discussion for the fourth quarter of 2015. We had a fun time doing this and James, so awesome to have you part of the group. Your comments were fantastic. I was so excited to be able to bring one of the members of our forum onto the show. I know a lot of the other people that participate in the forum. If this is something you guys want to try to join us for a conversation, you want to be on the show in the worst way, shoot us a message, and we’ll see what we can do to try to make it happen in the future.

But James, fantastic comments. Hari and Calin, thank you guys so much for your time. And it’s just so useful to hear some of your comments and just some of your ideas and most importantly, some of your questions. We just treasure it, we do and I know that our audience gets a lot out of it as well.

So if you want to learn more about Calin Yablonsky, go to inboundinteractive.ca. He can help you out with your local search engine optimization results. Hari Ramachandra, he has his website BitsBusiness. He writes some of the best articles on just anything and everything that’s business-related. He’s located out in Silicon Valley. He’s an executive over LinkedIn. So, Hari just comes with a wealth of knowledge from Silicon Valley. James Meirowsky, if you want to talk with James more because you can tell he’s got some fantastic questions, we’re going to have a link in our show notes to James’ Twitter profile. So, if you want to shoot him any kind of questions, you want to get involved in our forum, at the WarrenBuffettForum.com, or you can just go to The Investor’s Podcast. There’s a link there for our forum as well. But we just thank James so much for kind of standing our forum up and going in the right direction. So, thank you guys, and we’ll see you guys next week.

Outro  55:20

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