[00:03:25] Rebecca Hotsko: Now it’s back to a more normal range in the high seventies. And so this gets into the first investment theme I wanted to touch on today, which is one of the most common investment strategies I’ve heard from guests that I’ve had. Which is that we’re likely entering a new commodity bull cycle. And so back to the prices, even if we enter a recession, that would likely reduce the demand for oil in the near term.

[00:03:51] Rebecca Hotsko: So we might not see prices skyrocket back to where they were in the near term. But at these prices, companies are [00:04:00] still doing amazing. And so even if prices stay at these lower levels, energy companies are still cash-flowing machines, and this is well above their break even. But since energy has been such a high performer over the past year, it has gotten more expensive compared to history with the run up in prices.

[00:04:19] Rebecca Hotsko: And so I had to ask the question if it is too late to join the energy. Is it now overvalued since we saw this massive appreciation over the past year, and so I had to ask this question to a few of my guests, and here is what Louis Gave had to say about that. 

[00:04:39] Louis Gave.: Now, I don’t think energy is overvalued, not by long shots. I look at things like the coal miners in the US, for example, are training at two, three times earning. They’re buying back 10% of their shares a year. They’re far, far, far from being undervalued. They’re overvalued. Far, far, far from being over. And same story with a lot of the oil, oil companies Mean if you look, you’re based in Canada, if you look at some of the Canadian oil stocks, you take a tormaline, you take a a Suncor, these are not expensive stocks.

[00:05:11] Louis Gave.: These are actually cash flow generating machines. Now, historically, and this is what makes it for me energy particularly interesting, this in this cycle, historically, you know, your typical oral company ceo, when he gets money, the first thing he does is he goes drill a hole in the desert because otherwise he wouldn’t be an oil CEO.

[00:05:30] Louis Gave.: You know, that’s what they do. Get money drill. Here. All of a sudden this the, your oil company, c e o, he’s, no, nobody’s drilling, nobody’s doing any capital spending. And the reason he’s not drilling is because he’s got governments telling him, in five years, I want you out of business. So, you know, why is he going to do a big capital spending plan that comes due in three years?

[00:05:50] Louis Gave.: Why is he going to build a new refinery? Why is he going to build pipelines? He can’t even get environmental approval for. So now he gets, he’s generating amazing cash flows, and he really has no choice but to give these cash flows back to shareholders, either through special dividends or through share buybacks.

[00:06:08] Rebecca Hotsko: So that is the first big investment theme and strategy that I wanted to cover today because this is an industry where I will be watching closely as prices start to go down in the first half of the year, then I see that as a good opportunity to add more to my positions. So that’s energy. Now I want to move on to the other sectors.

[00:06:31] Rebecca Hotsko: So the rest of the 10 sectors were down. When looking at a one year relative perform. Some were pretty close to flat, like utilities and consumer defensive held up pretty well. But let’s talk about the absolute worst performing sectors of the year. So coming in first is the communication sector, which includes companies like Google and Meta.

[00:06:55] Rebecca Hotsko: And this sector as a whole is down about 40% for the year, and the sector is expected to report a 14.7% decline in earnings for the year. So this isn’t necessarily news to us. We know how badly these stocks have been beaten up over the year and at the company level. Google Meta and Warner Bros are the largest contributors to this expected earnings decline for the sector.

[00:07:21] Rebecca Hotsko: And if these three companies were excluded, the sector would actually be expected to report positive earnings growth of 1.3% rather than the decline of nearly 15. Now the second worst performer for the year was the consumer discretionary or consumer cyclical sector, which includes companies like Amazon, Etsy, eBay, and this sector is down 36% this year and is expected to report a decline in earnings of about 14%.

[00:07:53] Rebecca Hotsko: And at the company level, Amazon is the largest contributor to the expected earnings decline for the sector. If Amazon was excluded, The sector would actually be expected to report positive earnings growth of nearly 15% rather than a decline of almost 14%. And then the third worst performing sector is technology, which includes companies like Apple, Adobe, and this sector is down 31% for the year, but the earnings growth for this sector actually held up and is expected to be positive at 3.9% for the year.

[00:08:31] Rebecca Hotsko: So that wraps up what happened, but now that it’s 2023 with the knowledge that things are likely going to get worse in 2023, where it’s likely that earnings still need to downgrade about 20, 30% and the Fed is still expected to hike rates and communicated potentially reaching 5.25% by the end of 23 or until something breaks and they’re forced to pivot.

[00:08:59] Rebecca Hotsko: It begs the question of how should we be thinking about investing in this environment? Should we be buying the dip or should we be remaining more defensive as it’s likely that there’s more pain ahead? But at the same time, we won’t know when the Fed is actually going to pivot, when markets are going to rebound.

[00:09:19] Rebecca Hotsko: And so what do we do as prudent investors in this scenario? Well, I asked this question to my guest, Louis Gave in episode 235, and this is what he had to say. 

[00:09:32] Louis Gave.: So I think bear markets are there for a reason. They’re not fun. Obviously. Nobody, you know, we all like bull markets better. Bear, lot more exciting.

[00:09:39] Louis Gave.: Bear markets are there for a reason. Big bear markets like the ones where, because we are now in a big bear market, this is not a correction. Corrections, you buy the. Bear markets. What you do in a bear market is you wonder where is the next leadership going to come from? I think the tendency of most investors when they’re in a bear market is to hold onto the past cycles [00:10:00] winners to say, oh, you know what?

[00:10:01] Louis Gave.: I bought Teton here, or I bought Zoom Communications here, or I bought Facebook there and it’s going to come back because these are good companies and they’re going to come back over. But the reality is bear markets are there for a reason, and that’s to change leadership from one group of stock to the next.

[00:10:16] Louis Gave.: So while you’re in a bear market, what you should actually be doing is thinking, okay, where is the next leadership going to come from? And the best way to do that is to actually look at within while you’re going through the bear market, who is already outperforming, who’s already starting to shine. And today I would say there’s, there’s really two asset classes that are starting to shine.

[00:10:37] Louis Gave.: The first asset class is. Pretty much anything linked to energy has been outperforming. And the second asset class that’s been outperforming is emerging markets, especially if you exclude China, which is such a big part of the emerging market benchmark. But if you look at your Brazils, your Indias, your Indonesia’s, your South Africas, your Mexicos.

[00:10:58] Louis Gave.: All these markets are flat up for the year, which is dumbfounding in an environment of rising interest rates of strong US dollar that these markets are actually flat up for the year goes against any historical precedence. I think there’s a very strong message in both the outperformance of energy, you know, energy outperforming during an economic slowdown and in the emerging market outperformance.

[00:11:20] Louis Gave.: To me, it tells me that the next bull markets will focus on those two, maybe both, or either of these, or at least one of these two sectors. So in these two sectors, I want to buy the dip. You know, when I see energy dipping, yep, I’ll buy that. But the reality is you’re wasting your time, and more importantly, you’re wasting your capital if you’re still hoping for the turnaround.

[00:11:41] Louis Gave.: In Zoom, the turnaround in Facebook, the turnaround in Tesla, that ship is sailed. It’s gone. That was the previous bull market. The current bear market is marked the end of that bull market. Think about what the next bull market is going to be. It’s not going to be in the same place it never is. Lightning never strikes twice in the same.

[00:11:59] Rebecca Hotsko: So I wanted to include this clip again from Louie because I think his message is so important to remember for this coming year and for our strategies going forward where we might have to think differently about what’s going to become the biggest winners in this next bull cycle. And we can’t just hold on to the past winners and hope for the rebound in their performance because they did so well in the past.

[00:12:22] Rebecca Hotsko: And thinking about the biggest winners in the last bull market was really these big tech stocks. And at the same time though, these are the stocks that have been beaten down the most over the year, where Apple stock has lost about 18%. Well, Alphabet or Google has declined about 40%. Amazon has fallen 45%, and Meta has plunged over 70.

[00:12:47] Rebecca Hotsko: And so while I think in general it seems reasonable to believe that there’s going to be the secular changes and trends about who will be the biggest winners going forward, it’s not to say that all of these stocks were the previous best performers are going away or not going to perform well. And so I was wondering, are some of these big tech names beaten down too much to ignore at this point?

[00:13:12] Rebecca Hotsko: And so I had on Logan Kane, which is episode 2 39, where he did a deep dive on these technology stalk, including Apple and Google. And he talks about how despite Apple has held up the best of all the big tech companies, he believes Apple is the most overvalued tech stock of them all. And so here’s the clip on Logan’s analysis of Apple.

[00:13:37] Logan Kane: Apple stock is probably the most overvalued large cap stock, or borrowing Amazon or Tesla right now. So I’ll start our discussion of Apple. The couple of anomalies on the financial markets. The first is a disposition effect, which has historically kept Apple. What happen is Apple would go up, but it would always remain cheap.

[00:13:56] Logan Kane: The stock pretty much anytime from 2010 to [00:14:00] 2018, the stock was always cheap, but it had gone up in excess of 20% a year. I mean, depending on the time period, 30 plus percent per year. That’s because you know, people, they get a million dollars for investing in Apple and they go buy a boat. Or they buy a house and it, it keeps the stock down and it creates momentum.

[00:14:17] Logan Kane: The disposition effect creates momentum on socks, which is another good anomaly to know about socks that go. Tend to keep going up. Socks that go down, they tend to keep going down. It’s an old like it’s old focus. I’m on Wall Street, but it’s absolutely true. But what happened with Apple? Something changed around, I don’t know, maybe the summer of 2019 and this changed for a lot of socks and for the market at large.

[00:14:43] Logan Kane: And is that the Fed and the treasury kind of coordinated to juice the economy? And this massive asset price bubble started really wasn’t that bad in 2019, but for reference, Christmas Eve of 2018 on the market bottoms, I think it was Christmas Eve, I think Apple was like 10 or 12 times earnings on a forward basis, incredibly cheap.

[00:15:05] Logan Kane: And by the peak in a fourth quarter of 2021, it was like 40 times earnings. I mean, that’s just like, that’s some. How can the same company, their net income was basically flat over. I mean, you know, they bought back shares. So the e p s went up. The business was the same, but the stock was worth four times as much.

[00:15:24] Logan Kane: So if that is in evidence of some craziness in the market, inefficiency, if you will, that I don’t know what is. So basically with Apple is the. Profit from the business has stayed roughly flat and growled little. This wasn’t until the pandemic and then the, with the stimulus, a lot of customer or a lot of consumers got all this money and they couldn’t go travel.

[00:15:46] Logan Kane: They couldn’t do live entertainment, so they just slammed Apple author for iPhones and Apples profits like skyrocketed. This is not sustainable going forward. It’s not sustainable to put a very high multiple on that going forward. And as a result, Apple Stock is probably the most overvalued large cap stock or borrowing Amazon or Tesla right now.

[00:16:06] Logan Kane: I think if you just close your eyes, block out the stock price with Apple and say, what would accompany making this amount of money be worth? I think per share, I think you would get a price of somewhere between 75 and $95 a share. It was trading for almost 180 earlier. This year . 

[00:16:22] Rebecca Hotsko: Now I wanted to share that clip because I just really like the way Logan analyzes companies and his thought process, but he doesn’t think that it’s all doom and gloom for the tech stocks.

[00:16:32] Rebecca Hotsko: And he also shares in the episode why he thinks Google is the most undervalued tech stock and is a great buy anywhere under $90 per share. And so here’s a clip of Logan’s analysis of why he likes Google’s stock. 

[00:16:48] Logan Kane: Okay, so for Google, I like Google. I don’t like Apple. The reason why I like Google is because Google is projected to have double digit rates of growth for the next 5, 7, 10 years.

[00:17:00] Logan Kane: Now, the reason why I feel that is just the structural advantages that Google has, what’s search with the internet, with just the way as the world develops. Google is like, it’s like a toll booth in a lot of ways and Apple is too. But when you look at the consensus analyst estimates for growth, I mean Google’s around 15% a year for the next three years.

[00:17:19] Logan Kane: The their earnings are coming down this year, off of last year, because no covid boom ad advertising independent. Google is cheaper than Apple from a price to earnings perspective, but the growth is projected to be two to three temps as much. Moreover, Google spends a lot of money on r and d, and not that Apple doesn’t, but Google spends so much money on r and d that it makes the company look less profitable than it is.

[00:17:43] Logan Kane: So what you really get with Google is just like, Cash machine. Google is really the cash machine that Apple would like to be. It’s so much less visible, and you can see this looking at the returns over time, like Google has always been more steady. Google’s money comes from businesses. , even though everybody uses the product, their money comes from businesses.

[00:18:02] Logan Kane: Apple’s money comes from consumers. You go to the Apple store and be like, how? How busy is the Apple store? Like, or maybe we should buy some apple sock. So people have a tendency to invest a consumer discretionary socks at a disproportionate rate. So I’ll go into more of why I like Google. I think if you buy now, I think you get sufficient compensation for running the stock over a five year period.

[00:18:21] Logan Kane: I define sufficient compensation as 10%. Annual returns are greater. If you can get it cheaper, get it cheaper. I mean, anything under 90 is pretty good. Anything under 80 I think would be an absolute steal. 

[00:18:33] Rebecca Hotsko: I also asked him what he thinks about Google going forward because it’s business driven. Revenue might slow down more if we hit a recession and businesses can’t spend as much money on advertising and such things like that.

[00:18:46] Rebecca Hotsko: And so here’s what he had to say about how he’s thinking about these near term risk. 

[00:18:52] Logan Kane: So Google and companies like it are kind of an early warning side for a slowing economy. Google is not a recession proof stock. If I have a business and I think a recession is coming, advertising is one of the first things I’m going to cut.

[00:19:06] Logan Kane: That’s, that’s just how it is. So Google right now is they’re going to see their earnings decline. So, well, when I wrote my article on Google, I gave the earning estimates a haircut. I said, I don’t think these are going to hit in year one, but I think they’re going to be better than you think in year two, year three year.

[00:19:21] Logan Kane: That’s just because the economy’s going to slow down, and at some point it’s going to bottom out and it’s going to come back out. It’s cyclical. But if you look over the cycle at the earnings power of Google, I find it far superior to Apple. Another question is compensation. Almost all businesses have their problems, but if I can buy a stock for 10 times earnings for 15 times earnings, Those problems aren’t so bad.

[00:19:41] Logan Kane: If I’m paying 80 times earnings for a stock, a very small problem for the business is a very big problem for the stock. You need second order thinking to do well in the stock market. It’s not, if it were only a matter of saying give me the best businesses and just buy ’em, it’d be really easy. You’d just go out, you say, Hey, the store’s really busy.

[00:19:58] Logan Kane: I’m going to invest in the stock. But the valuation is like a point spread in this. Because the Liz Earn is going to be paid out as dividends investors. They can be reinvested in the business. They can be used to buy back stock In a lot of companies, case they do all three. So I think if you gave me a pick of a business, like do you want Google or do you want Apple?

[00:20:16] Logan Kane: I think I would still choose Google regardless of value. Like if the valuations were equal, I think I would still choose Google. But if the valuation for Apple were cheaper, I would like Apple. I would be all over Apple. If it was under like, I don’t know, 85, $80 a share, I’d be all over it . 

[00:20:32] Rebecca Hotsko: And the second major investment theme I want to talk about today is mean, revers.

[00:20:38] Rebecca Hotsko: This is one of the most important lessons I learned from speaking with guests over this year because mean reversion exists in markets in industries, it’s most commonly known as the boom in bus cycles within an economy or the different market cycles of the stock market. But even more than that, mean reversion also has really important impacts on company’s profitability.

[00:21:01] Rebecca Hotsko: And overall returns we can get as investors where it tends to pull down companies earning higher than average profits and higher than average return on invested capital back down to its mean. And it pulls up companies who have recently performed poorly. And it pushes them back up to its historical mean.

[00:21:20] Rebecca Hotsko: And that’s why the biggest losers tend to be the biggest gainers in the future. And so I had a few different guests talk about this in a few different contexts. And I want to start with Michael Gayed, who is one of the first people I interviewed, and he had this to say about mean reversion. 

[00:21:38] Michael Gayed: So there’s a well known phenomenon called the Morningstar Curse.

[00:21:43] Michael Gayed: Which basically says that if you were to take the top performing funds, top performing strategies over the last three years, the five star funds, and then look at how they behave the next three years, it ends up being that those top performing funds end up being among the worst performing funds in the next three years.

[00:21:57] Michael Gayed: Conversely, same is the same as also true, meaning that [00:22:00] the worst performing strategies and funds over the last five years or three years end up being oftentimes in the top decile for the next three, five years. In other words, there’s a degree of mean reversion . Right. That happens with strategies which are hot for a moment, and then go cold, and then cold goes to hot. Right Back and forth, back and forth, back and forth. 

[00:22:17] Michael Gayed: In many ways, sometimes the best investments are the ones that have done the absolute worst over the last several years, which is basically just a way of thinking about, another way framing. Buy low, sell high, right? The problem is FOMO often screws with people’s heads, right?

[00:22:32] Michael Gayed: They want to chase that, which is going. And they think they can trade it and get out just as the turn’s about to happen and all the evidence suggests that’s not true, but you have much more room for error. 

[00:22:43] Michael Gayed: You have much more cushion, obviously with things which have already done so poorly, where not too many people are trying to chase.

[00:22:48] Michael Gayed: It’s a long-winded answer by my point here, is that sometimes I often advocate that people should consider allocating to that, which has not done well at all by the way, like energy stocks, okay. Which, you know, [00:23:00] have been on fire. They’ve done poorly for a decade. But if you followed that, that suggestion that maybe the best thing to do is buy the, the biggest laggards over the last cycle, over the last several years, well, at some point, mean re version kicks in.

[00:23:12] Michael Gayed: At some point you end up having that which is last become first and first last. 

[00:23:17] Rebecca Hotsko: So I wanted to re-share these clips with you all today and include meaner version as one of my biggest topics and takeaways from the guests I’ve spoken with because it has so many important implications of what assets to buy, and it goes back to that contrarian mindset as well as how to be a good value investor, which is something that I learned more about after speaking with Tobias Carlisle on episode two 40.

[00:23:45] Rebecca Hotsko: Because at first the concept of mean reversion sounds so counterintuitive to me, where Toby explained how buying the losers tend to work out better than buying winners who are posting strong and growing profits over time for the simple fact that they tend to mean revert. But how this relates back to being a great value investor and just investor in general, is that there’s an exception to this, which is if a company has a sustainable competitive advantage, Warren Buffet calls it moat , then it is way more likely that this company can continue to earn these high rates of return on invested capital, high return on equity over time, and it won’t necessarily mean revert.

[00:24:29] Rebecca Hotsko: And this is where it all just started really clicking to me and why Warren Buffet really stress. The need for companies to have this element. He spends so much time talking about competitive advantages, why they’re important, and why it’s so important to look for these in the companies you’re investing in, especially if there are these high growth companies.

[00:24:49] Rebecca Hotsko: And so Toby touches on this in our episode and make some really great points on why it’s so hard to find companies with these sustainable competitive advantages. And so here is what he had to say about that. 

[00:25:02] Tobias Carlisle: One of the problems is that over time the market evolves and things that were regarded as being moats in the past are not.

[00:25:11] Tobias Carlisle: There are lots and lots of businesses that look like they have moats. Once the mode is crossed and all of that ability to gen, once the competitive advantage is eliminated, and that ability to generate the supernormal returns is gone. It’s very unlikely that they get it back again in the future, but you are often paying a premium price for those supernormal returns.

[00:25:29] Tobias Carlisle: So one of the exercises, this sort of built into my models, but one of the exercises that I do is if you have something that’s earning, say two times more than the average. So the average company in the S&P500 earns about 13.3% return on invested capital. And so if you find a business that’s earning more than that, you know that you’ve got, potentially you’ve got a special kind of business that it’s able to earn higher returns than.

[00:25:50] Tobias Carlisle: But you can see if that special business has a higher return than normal, than it, it’s also worth more than normal. And so it should trade at a premium to the average PE in the S and PFA fund, which might be around 19 times right now, something like that. People might buy that thinking that they can generate good returns going forward if they can sustain this high return on invested capital because it is true that the longer you hold, the closer your own investment.

[00:26:16] Tobias Carlisle: It trends towards the return and invested capital. So over the short period of time, your return is dictated by the multiple that you pay, but over time, it becomes the return and invested capital. So the reason that that’s important is if we also know that businesses have this tendency to mean reverse.

[00:26:33] Tobias Carlisle: So the return and invested capital drops. It makes sense that say it’s earning two times the average business and it’s worth two times on a multiple basis. If in 10 years time it’s earning the same amount as the average business, it’s also going to be only worth the same amount as the average business.

[00:26:48] Tobias Carlisle: So if I’ve paid twice the multiple and over 10 years, the multiple mean reverts down to the market multiple. What are the chances that I’ve actually made money over that period of time? And it turns out that [00:27:00] often it’s pretty low 10 years for, for mean reversion in most businesses. That’s about right.

[00:27:05] Tobias Carlisle: That’s about how long it takes on average, other than this very small portion, other than about 4% that earn these supernormal returns forever and ever. You can think about that. Michael Mob does this research all the time where he bris out. Here are the businesses that were able to earn supernormal returns over the last decade, and it’s backwards looking.

[00:27:22] Tobias Carlisle: What are the chances that those are the same businesses in 10 years time? It’s very low and often the best kind of investment opportunities are not the ones that have the supernormal returns on equity. It’s just the ones that are doing a little bit better than average. And they might be, you know, the companies that make up is a great business.

[00:27:39] Tobias Carlisle: Some of the, to businesses like that where they’ve got a little bit of recession protection built into them, that when, when times get really tough, people will still go. They can justify going buying expensive lipstick because it’s a smaller purchase, whereas they might not got, might have gone by Tesla when times are really.

[00:27:55] Tobias Carlisle: So they have a little bit of this invil protection in them, and people are quite habitual. They like their brand. So if they like a particular brand, they tend, it’s just easy to keep on going and buying that same brand. So you want to take advantage of those kinds of behaviors, things that will survive through a recession, because getting a zero on anything that you’re invested in is catastrophic.

[00:28:15] Tobias Carlisle: You should assume that you’re going to get some, but you should always keep everything small enough. So 100. And then looking for things where there is that habit and repeatability. So Starbucks is a great example. We all know that coffee’s addictive. People who like their coffee, it’s the little CRE that you can get once or twice a day.

[00:28:31] Tobias Carlisle: That’s a great habit. Starbucks is one of those businesses that has earned very high returns for most of its life. So it’s funny, it’s not the businesses that are the superstars that tend to be the ones that really do manage to sustain these high. It’s businesses that you might overlook them a little bit because they’re so, they’re ubiquitous, they’re common.

[00:28:50] Tobias Carlisle: You see them everywhere all the time, and you, they’re just sort of part of the landscape. But they are the ones that do tend to generate sustainable high returns and invest capital over time. But you also have to be careful. You have to bear in mind that at any point in time they can mean revert back down to an average business.

[00:29:04] Tobias Carlisle: And so you should buy them with that in mind, where if they do sustain those high returns and invest capital, you generate this great return. If they. He’s still going to get roughly a market return. 

[00:29:15] Rebecca Hotsko: Now that wraps up my investment theme number two on mean reversion. And now the next biggest lesson I want to talk about came from something Logan Kane said on how to become a better investor.

[00:29:28] Logan Kane: So there’s this thing, it’s called the Fundamental Law of Active Management. To be a good investor, you either need to be able to make a lot of bets at a low percentage. Like if you could win 51% on a thousand bets, or you could be Warren Buffet and you could win, I don’t know, 80, 90% on 10 bets. There’s really no right way to go about it.

[00:29:48] Logan Kane: Like business, like life. There’s multiple ways to do it, and one of the great things about investing in business is there’s literally a million ways you can do it. What I like and what I think is the easiest is to take more of a quantitative approach. You can always do some value investments as they come up.

[00:30:05] Logan Kane: What I like about the quantitative approach is it takes a lot of our biases out of the way. Like we might think Apple’s a great stock, but the computer might look at it, it might say, oh, you know, at apple’s 30, 40 times earnings, people are kind of excited about it, but you know, you don’t really see it. If you want to be a value investor or you want to be like buffet.

[00:30:23] Logan Kane: There’s a very important trap that a lot of beginning and intermediate and even professional investors fall into what it’s known as is the disposition. So the tendency is if we make a portfolio and we invest in a hundred stocks, so over time our human tendency is to hold on to the losers and try to get them back to even, and we sell the winners.

[00:30:45] Logan Kane: Now, research shows that this cost investors, I’ve seen 4% a year up to six, sometimes even 7% a year. And this one effect has been shown. Account for a lot of the mutual fund under performance versus the S&P500. So the nice thing about these quant funds, like, and a lot of these are just etf. They automatically hold the winners and they automatically dump the losers.

[00:31:10] Logan Kane: But this is a huge advantage. So back to the fundamental law of active management, there’s only two ways to be a better investor, you have to make better forecasts, or you have to be able to use those forecasts on a wider number of stocks and investments. I personally, I mean, I know my own limitations. I mean, I consider myself pretty smart, but I’m not like, I’m not that.

[00:31:31] Logan Kane: So it’s a lot easier and it’s a lot more low hanging fruit to increase the diversification rather than to know everything about a handful of stocks and constantly say on top of them. 

[00:31:45] Rebecca Hotsko: So what I really like about his point here and why I wanted to include it as one of my biggest lessons for this episode is that there are so many different strategies to make money in the.

[00:31:56] Rebecca Hotsko: And really these two ways to become better investors. Neither is better. It comes down to your preference and which you enjoy more. You feel like you have an edge in investing in certain businesses. Do you enjoy doing fundamental analysis and diving deep into companies? Or are you someone who likes investing but you don’t want to spend a whole lot of time on individual companies.

[00:32:20] Rebecca Hotsko: And so I want to jump into both of these strategies more in detail because I’ve had on guests that talk about both on the show. And so if you are someone who loves the value investing side of things and you want to pick companies, maybe you follow a Warren Buffet sell value investing strategy. . Well, I wanted to include my top takeaways of how to become a better value investor from Robert Hagstrom, who is an expert in the space.

[00:32:47] Rebecca Hotsko: He has written several books on Buffett, and he gave us some great advice and his top tips on how we can become better value investors, how Warren thinks about investing, and the top things that we can take from his strategy and apply to our. So here is my clip with Robert Hagstrom on the most important things to becoming a better value investor.

[00:33:13] Robert Hagstrom: Well, I, I think it can be summarized very simply in, is that Warren has a totally different orientation to the stock market than what I observe 99% of the people do. By that, I think too many people spend too much time trying to guess stock prices and what stock prices will do in the short. And Warren doesn’t think about the market in that way.

[00:33:34] Robert Hagstrom: He thinks about stock prices as being businesses, and he is more focused on what’s going on with the business. The economics of the business and the stock prices is almost an afterthought. He just doesn’t spend a whole lot of time thinking about markets, stock prices, sectors, things like that. He just wants to be a business owner and isolates some really great businesses for his portfolio, and that’s where he spends the vast majority of his time as being a business investor, not a stock picker.

[00:34:01] Rebecca Hotsko: And I think the other thing I want to point out here is, regardless if you want to be a Warren Buffet type value investor, there’s still a ton we can learn from Buffet and the way he invests. The first is how to think of stocks as businesses and from a business owner mentality. And then from there, Warren looks at what are the major tenants or things you would look for in a business if you are looking at it from this business owner perspective.

[00:34:26] Rebecca Hotsko: So having this framework in. I think regardless of which approach you’re taking, can help you become a better stock picker with any strategy that you’re trying to implement. And so here are the four tenants that Robert talks about each business needs to make for him to invest in it. 

[00:34:43] Robert Hagstrom: We like to buy, you know, businesses that are simple and understandable, that have, you know, good, favorable long-term prospects.

[00:34:49] Robert Hagstrom: And I went, ah, business tenants check. And you know, we like companies that generate a lot of cash, earn high returns on capital high, high profit margins. Oh, financial tenants check. They got that part right. [00:35:00] We want management, the things independently that’s rational about how they allocate capital check.

[00:35:04] Robert Hagstrom: They got the management part right? And then lastly, oh, we always buy ’em below intrinsic value. And I say, oh, that’s, that’s exactly the warm month away. This is perfect. Then I wouldn’t look at their portfolio. There’s two parts. It is thinking about stocks as businesses. Then if you’re a business owner, How would you think about a collection of businesses?

[00:35:20] Robert Hagstrom: If you had great businesses, you wouldn’t want to trade ’em all the time. If you had great businesses, you’d want to hang onto ’em because that’s once you, you know, growing your net worth over time. So those are kind of the two parts of the Warren Buffet approach, a stock selection approach and a portfolio management approach.

[00:35:35] Rebecca Hotsko: So the last key theme I want to touch on regarding value investing or just stock picking is how do you know how concentrated to go as Warren was very concentrated in his positions? And even more than that, how do you decide if this is the right strategy for you at all? And so here’s a clip of some insights that Robert shares on this.

[00:35:59] Robert Hagstrom: I think that’s, it’s an excellent question and I think you’ve kind of got the boundaries around it quite right, so let’s go back if, if you can actually analyze companies and you think about ’em as businesses, you understand the cash, you understand the return on capital, you understand the competitive advantage period, how long this will last, you can actually do, you know, cash flow analysis and do dividend discount models, which are all, you know, by the time you’re a freshman in college, you’ve got that stuff figured out.

[00:36:23] Robert Hagstrom: If you can do that, Then really it’s in your best interest on fewer stocks, not more stocks, because you’re basically concentrating your beds on those things that have the highest probability of generating, you know, high returns over time. If you don’t have that confidence or you don’t have that insight about businesses and how to think about valuation and stuff like that, as, as Warren says, you’re a no nothing investor, then you want to diversify.

[00:36:47] Robert Hagstrom: Warren said there’s nothing wrong with. You know, it actually outperforms the vast majority of active managers. And so there’s nothing wrong with it. You’ve just got to align your portfolio with your skillset. And if you said, if you do have the skills to think about stocks as businesses and do good analysis, only fewer stocks and holding ’em longer term, it’s better than owning lots of stocks and turning them over.

[00:37:07] Robert Hagstrom: But if you don’t know, you know, if you’re not a good business analyst, you don’t have that confidence level, then you certainly, you certainly want to probably diversify 

[00:37:16] Rebecca Hotsko: So I wanted to include this particular clip because I love what Robert says here, where it’s best to align your portfolio with your skillset and be realistic about what your skillset is.

[00:37:28] Rebecca Hotsko: Because as he mentions, most active strategies actually tend to underperform passive strategies over the long run. And so if you are an investor who is buying stocks because you think that is the best way to generate higher than market returns, All the evidence points, the fact that that actually isn’t true over the long term, and it’s because of the simple fact that this is so hard to do consistently.

[00:37:52] Rebecca Hotsko: And so I had a guest on Larry Swedroe who shared some really interesting research on this topic. 

[00:37:59] Larry Swedroe: Today now, and I wrote a book called The Incredible Shrinking Alpha with my friend Andy Ergen showed why it’s actually getting harder and harder to outperform the market that those numbers are down to 2% and 1% after taxes or so, and that was as far back as 10 years ago, so it’s probably even less today.

[00:38:23] Larry Swedroe: Here’s the way to think about. The people who are engaged in active investing certainly have the chance to win that game. Can’t rule it out, but the odds of doing so are so poor that obviously the prune strategy is to choose not to play it. The stock market, if you just born and owned the market and reinvest any dividends over time, you would’ve gotten about a 10%.

[00:38:50] Larry Swedroe: Now if you ask people, you know, if you bought an individual stock, what percent of them outperform? Most people would think, well, it’s probably 50 50, [00:39:00] and it’s nowhere near that far. Fewer stocks beat the market than people think. In fact, here’s a number that’s probably going to shock you, Rebecca, even though you’ve read my.

[00:39:13] Larry Swedroe: Which is this. If you look at the excess return of stocks over treasury bills, that’s called the risk premium for equities, right? So you should earn an excess return for taking that risk. Only 4% of all the stocks one in 25 account for 100% of all the excess return of. Now, what are the odds you are going to find those stocks and hold them for the entire time to make sure you capture those gains here?

[00:39:45] Larry Swedroe: Most stocks underperform the market and therefore, as you add more stocks to your portfolio, you’re increasing the chances of getting the median return and the mean return for stocks, you own a few stocks, which is unfortunately what most people tend to do are individual investors. You have, do you have a chance to hit that home run and find the next Google or Microsoft, but the odds are greatly against you.

[00:40:13] Larry Swedroe: And unfortunately, all the research on individual investors show that the vast majority of them underperform. In fact, the stocks that they buy on average go on to underperform after they buy them, and the stocks they sell go on to outperform after they sell course. Since the zero sum game, someone’s on the other side, turns out it’s the smarter institutional investors who are exploiting dumb retail money.

[00:40:44] Rebecca Hotsko: So I really like this conversation with Larry, and I wanted to include this clip because I think he makes some really great points on why it’s so hard to beat the market for the average investor and why it’s so hard to do it consistently. And if you’re an investor who thinks, well, I don’t know if I have the skill to pick the 4% of stocks that have historically made up all of the excess returns.

[00:41:04] Rebecca Hotsko: Or if you’re just realistic with yourself and you know your limitations as an investor, you are out of luck and you don’t have to just accept market returns. There are other strategies that you can implement and still do very well and even beat the market. And this goes back to what Logan said about the fundamental law of active management, where you either have to make better forecasts or you can use those forecasts on a wider range of stocks.

[00:41:31] Rebecca Hotsko: And so the latter is talking about a more quantitative approach where you’re just saying, I want to spread my bets. I don’t really know what’s going to happen in the future, but I do know what characteristics typically do better over time. And so I’m just going to buy a lot of. So I brought on Toby Carlisle on episode 2 42 to talk about his acQuire’s multiple strategy, which is a quantitative deep value approach.

[00:41:55] Rebecca Hotsko: And what’s really great about it is it removes the need for you to be a superior business analyst and pick the right company. And what’s even more interesting is that Toby shows through his back test that his strategy has actually outperformed Warren Buffett’s strategy of buying wonderful companies at a fair price.

[00:42:13] Rebecca Hotsko: And so here’s the clip with Toby talking about his strategy versus Warren Buffet’s. 

[00:42:20] Tobias Carlisle: Buffet is well known for, he’s a value investor, first of all, so that means that he’s trying to identify companies that are trading for less than their worth, and then to buy them with the idea that over time, mean reversion takes the underlying value to the price, or vice versa.

[00:42:37] Tobias Carlisle: The price of the. He has said many times that given that value is a very broad church, there’s a lot of different ways that you can invest in value, and what Buffet is looking for is a company that grows over time. You’re getting the improvement in the, in the intrinsic value at the same time that you’re hoping for the discount between the price that you pay and the intrinsic value to close.

[00:42:59] Tobias Carlisle: So what he has said is that he looks for wonderful companies at fair prices. So he defines a wonderful company as a company that has a high return and invested capital. So that’s the amount of money that the company earns scaled by the amount of money that it has that is invested in the business to generate those returns.

[00:43:18] Tobias Carlisle: It’s not a simple process to say, we’re just going to buy wonderful businesses. Fair price. If you’re looking for a simple approach, a quantitative approach, it’s better to say we’re going to try and buy fair companies at wonderful prices, which is to say, let’s just say we have no ability to figure out how high quality these businesses are.

[00:43:37] Tobias Carlisle: For the most part, that does seem to be the case. Statistically, historically, it’s extremely difficult to find sustained high returns on investors. I think I’ve often said that it, it looks like it’s about 4% of businesses, statistically, quantitatively have this sustained high returns and invest capital.

[00:43:54] Tobias Carlisle: I saw Charlie Mango is reported to have asked this question of one of the, the Ted, Ted or Todd, one of the guys who invest, one of the newer guys at Bocher who’s investing Bocher Capital. They said, he asked them, what, what percentage of businesses do you think will be better in five years time? What percentage of S&P500 businesses?

[00:44:13] Tobias Carlisle: And say it was Todd, his response was, I think it’s about 5% of businesses, and Manga said it’s about 2% of businesses. And so what my response is 4% of businesses, I think that sits about halfway between the two. Statistically speaking, that’s about the case. So what we’re saying is if we have no ability to predict what the future is going to look like, It does seem to be that there is some evidence that that is in fact the case.

[00:44:36] Tobias Carlisle: Nobody really knows what’s going to happen. If you dunno what’s going to happen, then you want to get as many factors on your side. If you have a good outcome and you’ve paid modestly for a business, you tend to have an outsized return in the market. If you have a bad outcome for a company that you’ve paid up for, you have an outsized return in the other direction.

[00:44:55] Tobias Carlisle: So basically what my approach is just to say, let’s be honest about what we do know and what we don’t know. How do we protect ourselves in those circumstances? In the way that I say that you can protect yourself is by paying as little as possible and not trying to work out which really are the better businesses, but otherwise, because you’ll find that it’s quite confounding, it’s quite hard to sort of predict these things into the future.

[00:45:16] Tobias Carlisle: At least that’s, that’s what my research shows. 

[00:45:19] Rebecca Hotsko: So another strategy that is somewhat similar to Toby’s approach is Factor Investing. And the reason I say it’s similar is because this is a quantitative approach that involves using specific characteristics of stocks such as value stocks, high quality, high profitability, and momentum to improve your expected returns over time.

[00:45:42] Rebecca Hotsko: So I did a whole mini episode on what Factor Investing is, which is episode two 19. If you haven’t listened to it. And here’s a clip from my interview with Larry Swedroe talking all about what factor investing is. 

[00:45:55] Larry Swedroe: The research and I wrote a book called Your Complete Guide to Factor-Based Investing, and that really shown that there are certain traits or characteristics.

[00:46:06] Larry Swedroe: That’s what a factor means. It’s a trait or a characteristics, large stocks or companies that have high market capitalizations like the stocks and the S&P500. And then you could have small stocks that may have valuation in the a hundred million dollar. You have value stocks, which are cheap stocks.

[00:46:25] Larry Swedroe: They treat in low PEs or growth stocks, which are defined as high PE stocks. Warren Buffet had been telling investors for decades that he beat the market because he bought cheap stocks that were more profitable and they were higher quality. They didn’t have a lot of volatility in their earnings. Not a lot of leverage on their balance.

[00:46:48] Larry Swedroe: So academics went in and reverse engineered that. Of course, it took ’em 50 years to figure out what Buffet had been telling people for decades. But eventually they found this. Let’s see if we can identify what the stocks are that Buffet says. You should buy. And if we can identify that there are common traits, then we can just buy an index of those stocks or create an index of that, and we don’t have to do any research into that.

[00:47:18] Larry Swedroe: Or is it that Buffet’s a Greek stock picker? Now, most people would say Buffet was a great stock picker. Research says that’s not true. Buffet’s genius was the identified these traits well before others. And in that first book at the time, academics had identified two factors or traits that allowed you over time to outperform the market and they were valued.

[00:47:43] Larry Swedroe: So buy, cheat, and buy smaller stocks. So the highest inspected and historically highest returning stocks were small. But that only explained about two thirds of Buffett’s success or his outperformance. So the academics kept trying to drill down and eventually found that there were two other characteristics.

[00:48:04] Larry Swedroe: One, profitable stocks. So if you bought stocks with high return on assets, high return on equity, high gross margins are high and quality. So they had these other traits or more stable earnings. If you just bought an index in those stocks, you basically match Buffett’s performance. And his alpha, all his alpha performance virtually disappears.

[00:48:30] Larry Swedroe: So his genius not taking anything away from him, because he figured this out five decades before the academics was at identifying these. And Buffet has not outperformed the these types of indices for the last 13 years or so. And the market has become much more efficient because at the managers, for example, used to be able to say, for example, when I wrote my first book in 98, if you bought small value stocks that were more [00:49:00] profitable and higher quality, you could claim you were outperforming even on a risk adjusted basis.

[00:49:06] Larry Swedroe: But since 2013, you can’t do that anymore because all the funds that I owned and others owned and their ETFs incorporate that and they buy all these stocks. So you have to make, we are able to benchmark it against an a better measure. 

[00:49:24] Rebecca Hotsko: Okay. That is all I have for this year end episode. I just wanted to say thank you so much to everyone that has continued to support the channel.

[00:49:33] Rebecca Hotsko: It truly means a lot to. And one of my goals for this year is I want to make this community more interactive, and I’ve been getting more people reach out to me on my Instagram, which I absolutely love. So feel free to add me on there and reach out. I’ve updated my handle from Millennial Investing Podcast to rebecca.hotsko.

[00:49:55] Rebecca Hotsko: Go. So that’s linked in the show notes. And feel free to message me anytime with topics you would like me to cover in future episodes, guest suggestions, or even just any investment or market questions you have. And then I can use that to find the best guest to come on the show to help answer them. I’m always interested to know what kind of content you guys like best and want to hear more of.

[00:50:17] Rebecca Hotsko: So the best way is to reach me on Instagram. All right. That is all I have. I hope you guys enjoyed today’s episode, and I will see you again next week. 

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