Robert Leonard (00:02:23):
When you first get into investing, most people follow the ‘famous investors.” Some of whom are famous for good reason and deserve following, maybe like Buffett, while others might not be so worth following. Then as you get a bit more seasoned with investing your philosophy on who to follow changes a bit. At least that was the journey that I went through.

Robert Leonard (00:02:45):
I originally followed guys like Buffett and Ackman and others like them in hopes to get to the next hot stock tip. That’s really all I was looking for, was I just wanted the next hot stock. Today I still follow those guys, Buffett, and people like him, of course, but I’ve also learned that I prefer to follow people that have a great way of thinking, rather than just looking for a stock tip. I’ve also learned that a lot of times, those people aren’t always the most popular or famous, and that led me to you.

Robert Leonard (00:03:13):
I really enjoy the way you think and explain things, which has always led to our conversations in episodes covering a really wide range of topics. Today I think the conversation is going to be no different. Let’s start out with a new story that recently broke that I personally think is fascinating and it’s about Peter Thiel’s $5 billion IRA. For those who don’t know, give us a quick overview of just what a Roth IRA is, and then walk us through a little bit about Thiel’s situation and how that came about.

Ben Felix (00:03:43):
Sure. I’m definitely not the best person to give the nitty-gritty on how a Roth IRA works because I’m in Canada. We have a TFSA, which is very similar to a tax-free savings account, but you can actually talk broadly about these accounts because many countries have them. The tax-free account, which is the umbrella that these would fall under, there’re accounts where you contribute with after-tax dollars and when you withdraw in the future, you’re not taxed on the withdrawal, and that’s as opposed to a tax-deferred account where you contribute with pre-tax dollars and you’re taxed on your eventual withdrawals.

Ben Felix (00:04:13):
Anyway, so you get contribution room, you make a contribution with after-tax dollars and by doing that, you use up some of your contribution room. That Peter Thiel story is interesting, of course, because he has this massive tax-free account. I mentioned that after-tax dollars go in and you’re not taxed on future withdrawals.

Ben Felix (00:04:33):
If you get really big wins, and especially multiple big wins inside of that tax-free account, you can end up with a huge tax-free pile of money. That happened in this case. I think the problem with any individual investors getting too excited about this idea is that those outcomes like the Peter Thiel outcome, those don’t happen very often.

Ben Felix (00:04:56):
It’s true. It is a fact, that if you put money inside of your Roth IRA or your tax-free savings account if you’re in Canada and you make massive returns, you can end up with this big pile of tax-free wealth. But the chances of getting that many compounding big, huge, huge wins, we’re not talking about a 100% return here. These are serious returns that in Peter Thiel’s case, he got from investing in companies before they were public.

Ben Felix (00:05:24):
That’s not illegal. It’s not insider trading or anything like that, but it takes a certain amount of conviction, and I would say a certain amount of luck to get the kind of outcome that he’s gotten. Is it possible for an individual, someone listening to this podcast to recreate that experience by picking stocks or picking pre-IPO stocks?

Ben Felix (00:05:41):
It’s possible, but there’s this issue called skewness. Not an issue. It’s a statistical term called skewness in the stock market, in anything I guess, but in the stock market, the way the skewness works is that a few companies are responsible for most of the positive return in the market and most companies actually don’t do well. If you can pick those few companies that do really well and do so consistently with money inside of a tax-free account, you can accrue significant amounts of tax-free wealth. But the chances of doing that are really low because most companies don’t do very well.

Ben Felix (00:06:11):
Now, in this specific case where we have a $5 billion tax-free account, that wasn’t happening in the public market. It was happening with private companies. The skewness in, if we take venture capital as an example, the skewness in venture capital is even more extreme than in the stock market. Again, the probability of recreating this experience gets even lower.

Ben Felix (00:06:31):
Now, if it were free to do this, if it were risk-free to do it, maybe it’s like, hey, it’s a lottery ticket. Maybe you go for it. But the big problem is with these tax-free accounts, when you make a contribution, you use up your room. If you make a contribution and invest in some highly speculative thing because you want to recreate the $5 billion Roth IRA experience, and you lose the money instead of making the crazy multiple returns, that’s it. The room’s gone.

Ben Felix (00:06:58):
You make a contribution, invest in something that goes to zero, you can no longer use that contribution room ever. Keeping in mind, the skewness in stock returns or even more so in private investment returns, your chances of evaporating your tax-free room are much greater than your chances of creating a massive pile of tax-free wealth. Then there’s one other issue. This is actually one of my very first YouTube videos. My earliest YouTube videos was talking about exactly this for the tax-free savings account in Canada.

Ben Felix (00:07:27):
The other issue is that both in Canada and in the U.S., if you have a capital loss in a taxable investment account, so if you invest in something and then sell it later for less than you paid for it in general terms, then you get a capital loss, which you can use to offset a capital gain. Or it may be slightly different in the U.S. where you may be able to offset other income too. I’m not sure. But either way, you can offset capital gains with capital losses.

Ben Felix (00:07:53):
By having losses in your tax-free account, again, you lose that. Not only are you potentially evaporating your room, you’re also potentially giving up the opportunity to have capital losses which you can use to offset future or current capital gains. Again, I come back to the skewness issue, you’re much more likely to have losses if you’re doing speculative investments than you are to have wins.

Ben Felix (00:08:16):
My view on this is that I would save your tax-free room for your safer, more diversified investments, where you actually expect a long-term return and do your speculative stuff in a taxable account where, because you’re more likely to lose, you’re at least going to be able to use those losses to offset capital gains.

Robert Leonard (00:08:34):
The other piece to this, or nuances that Peter Thiel, because some people are probably wondering, how did Thiel use a Roth IRA to invest in private companies? When I go into my Roth IRA, all I can do is invest in public companies. The piece here, a little bit of nuance is that Thiel used what’s called a self-directed IRA. It’s a form of a Roth IRA and what you’re allowed to do with self-directed IRA is it allows you to then invest in a ton of different alternative assets.

Robert Leonard (00:09:00):
You can invest in cryptocurrency, real estate, you can put it in private companies, you can put it also in the public markets. But basically, you have a lot more flexibility in terms of what you can invest in. We actually just did a full two-part series, all about self-directed IRAs on the August 2nd and August 9th episode, so those are episodes 81 and 82. If you’re really interested in this idea of the nuances of the accounts themselves, the legalities, and all of that information, we also talked about Peter Thiel a little bit, go and check out those episodes.

Robert Leonard (00:09:30):
You talked about your opinion in terms of the strategy for where to allocate risky investments. But I’m curious to hear from a tax perspective, what your opinion is on Thiel’s approach. Some people think that it was brilliant and that, “Hey, he has the tax code. This is the way it’s written. It’s fine that he did this.” Other people think it was a little bit unethical. Where do you fall, do you think on Thiel’s strategy?

Ben Felix (00:09:54):
Well, the laws are what they are and he used them to his advantage. Is that unethical? I don’t know if I can make that judgment. Should the rules change? Yeah, maybe. If it’s relatively easy for someone with significant wealth to recreate what he’s been able to do, and I don’t know how true that is. We talked about skewness, we talked about luck. I don’t know if anybody can just decide that they’re going to recreate this experience.

Ben Felix (00:10:20):
But to the extent that it’s possible and that it’s a huge advantage to somebody with wealth, I can see an argument for that needing to change. But again, I don’t know if I’m in a position to make the judgment on the ethics of what he was able to accomplish.

Robert Leonard (00:10:35):
If anybody listening is familiar with Berkshire Hathaway and the potential investment gurus that Buffett has brought into Berkshire Hathaway there, Ted and Todd and Ted, the half of Ted and Todd, Ted Weschler, has an account just like Thiel. It’s not worth billions. It’s actually worth a little over 200 million, roughly 250 million. Ted has said, “Listen, should the rules be changed? Probably. Guys like me probably shouldn’t be able to do this, but I am able to so why wouldn’t I do this?” There’s an argument to be said as to whether things should be changed in the future and how you should look at it now, but I always find it interesting to think about that dynamic.

Ben Felix (00:11:16):
I think it’s a judgment that everybody’s got to make on. The laws changing, that’s a consensus decision to an extent. Dealing with clients, there are things in the Canadian tax code that you can do to save tax and they’re not by any means aggressive tax planning or illegal or anything like that. But there are things that you can do, and in many cases, probably a minority, but in many cases, I will have a conversation with a client about, “Hey, we can set this thing up and it’ll reduce your tax bill.”

Ben Felix (00:11:42):
Sometimes people say, “You know what? I’m actually okay with paying the tax because it feels like the right thing to do.” In a lot of ways, it’s a judgment that people have to make on their own within the laws that are in place.

Robert Leonard (00:11:53):
I think one of the viewpoints that comes into play here for a lot of people that think it’s unethical is that they think that it’s not possible for them or that they don’t have access to it when technically speaking, they do have access. Anybody can open an STIRA. Anybody can invest in pre-IPO companies.

Robert Leonard (00:12:09):
Now, could you get access to Facebook and PayPal like Thiel did? Probably not. There’s a debate there, but I think a lot of times the confusion or opinions are based on this idea of not having access like these guys do. I don’t know if that’s necessarily the case.

Ben Felix (00:12:25):
It gets interesting because if we forget about the tax stuff for a second and just think about access to deals, to the best deals, that is, I think pretty restricted to a relatively small subset of people of the top VC firms and maybe the top people like Thiel. That’s probably, then take it back to the tax conversation and the access conversation. It’s very possibly true that this isn’t something that’s accessible to the average person. Because you’re right, most people couldn’t access Facebook or IPO.

Ben Felix (00:12:52):
Any company that’s a unicorn like that and that everybody knows is going to have a big pop on IPO, those are really hard to access. There’s actually some interesting research on this too. We’ve talked about what an IPO is in a previous conversation that you and I had, but there are adverse selections and IPO occasions. If you can get access to a pre-IPO allocation, it’s probably not one that you want to access. Because the access goes to the people that generate the most revenue for the investment bank or its related businesses. It’s not easy to get access to those deals.

Ben Felix (00:13:23):
Again, we come back to skewness, and if we come to the evidence on VC investing for a second, there is evidence of persistence in VC fund managers. You take stocks, you take even private equity, there’s not a whole lot of evidence of persistence. That means that the best managers over a period of time don’t tend to be the best managers over a future period of time. But VC is one area where there is actually evidence of persistence.

Ben Felix (00:13:49):
Probably, it’s because of deal flow, because the best VCs get access to the best deals. But that also means that everybody else doesn’t get access to those deals. Even with a VC, with the best VC funds, one of the other issues is they still have a limited amount of capacity. If you have access to the best VC fund, you’re probably not going to get as big of an allocation as you want. Even if you have access, and most people don’t. Most people, they won’t answer your call.

Ben Felix (00:14:15):
But if you happen to be somebody that does have access to the best VC fund managers and they take your money, it’s probably not going to be as big of an allocation as you wished. For the people that get access to that type of investment opportunity, it’s probably not even going to be enough to move the needle in terms of that person’s wealth.

Ben Felix (00:14:30):
To your point about fairness and why this is seen as an issue, it may be possible for anybody to open a self-directed Roth IRA and technically access deals like this. But practically speaking, probably not going to happen. If we take the fairness angle, I would say that it probably isn’t. It isn’t fair just because of access to deal flow.

Robert Leonard (00:14:50):
I completely agree. I think technically speaking, it is possible but in reality, it’s not. There’s a story about how Peter Thiel actually, he recounts this experience that he had, where he went to Harvard and met Zuckerberg while he was starting Facebook. I actually worked one mile from Harvard, but still, nonetheless, we’re not going on Harvard campus and needing these future Mark Zuckerbergs. But guys like Thiel can and these VCs can, and that’s a different piece that you have, I guess, available to you when you’re these investors.

Robert Leonard (00:15:20):
The other piece too, is you have to be an accredited investor, which a lot of people aren’t. Even if you open a self-directed IRA and you found Facebook, let’s just say somehow that was possible, you then also have to be an accredited investor. There are all these different pieces that have to fit together and it’s hard. It’s hard unless you’re a guy like Thiel.

Robert Leonard (00:15:38):
When we’re talking about Thiel’s IRA and some strategies that might not work for everyday investors, talk to us about what an endowment fund is, who David Swensen was, and then take us through what an endowment model is.

Ben Felix (00:15:51):
Okay. I’ll start with what an endowment is. It’s a big pile of money and it’s used to fund the operations or help fund the operations of usually a charitable organization or a not-for-profit. A lot of universities are going to have big endowment funds. Harvard is pretty famous for having the biggest of any university, but including the Ivy leagues.

Ben Felix (00:16:14):
It’s Yale though, that’s where Swensen was and then Swensen in the past tense, he passed away earlier this year, unfortunately. Swensen was at Yale and he made a name for himself. He made a name for Yale and he even made a name for this approach to investing. It’s no one now just as the endowment model, but that’s pioneered by Swensen’s ideas which were unconventional at the time. Now they’re not so unconventional because everyone tried to emulate his model because of its success.

Ben Felix (00:16:44):
It was in ’85 that he took over Yale’s endowment and since then up until he passed, the results of Yale’s endowment have been phenomenal. Just ridiculously good compared to public stocks, compared to other endowments and institutional investors, so that success… It’s interesting to tie it into that idea of outcomes. We started this conversation with you talking about following people instead of following processes.

Ben Felix (00:17:12):
You can argue that Swensen has a process that you could try and replicate, and we’ll talk more about how that’s gone for other institutions in a second, but in a lot of ways, this is another example of outcome bias, where everybody sees the success of Swensen and it’s like, wow, Yale’s endowment’s just exploding because of the returns. And that outcome leads other institutions to want to replicate the same thing. That’s exactly what has happened.

Ben Felix (00:17:36):
If you look around today, the big institutions like the pension funds, the university endowments, even sovereign wealth funds, they invest similar to what Swensen introduced. Haven’t even talked really about what that is. But basically, he was big on active management and he was big on alternative asset classes.

Ben Felix (00:17:56):
We’re talking about hedge funds, private equity, private real estate, commodities, stuff like that. Back in 1985, most endowments were [inaudible 00:18:05] like bonds, maybe stocks, but he comes with this very unconventional approach, knocks it out of the park and everybody wants to do the same thing. He’s got a book. Swensen has got a book, Pioneering Portfolio Management, where he talks about a lot of these ideas, and so he explains the approach in there.

Ben Felix (00:18:22):
It’s diversifying across traditional asset classes like publicly traded stocks and bonds, and also alternative asset classes like we just mentioned. He talks about absolute return hedge funds, real estate, private equity, and venture capital as being some of the big ones. If you look on Yale’s endowment website, they talk a lot about their process there too and they explained that they use a combination of mean-variance analysis. That’s like statistical optimization. And market judgment, they set the target asset class weights in their portfolio.

Ben Felix (00:18:52):
This is one of the keys to their approach. They then hire active managers, external active managers to manage each allocation. That’s another one of the things that’s a little bit unconventional, and even now, there are competing endowment models. There’s a model known as the Canada model, which is pioneered by the Canada Pension Plan. It’s like Canada’s version of social security.

Ben Felix (00:19:13):
And they do something that’s in some ways similar to Swensen’s approach but instead of hiring external managers, which tend to be much more expensive, they hire talent internally and try and develop it to do the same kind of stuff but without paying the higher fees of external active management. Anyway, a bit of a digression there.

Ben Felix (00:19:29):
The current mix of Yale’s endowment fund for the fiscal year 2021, the target mix, they had 23.5% in absolute return hedge funds, 23.5% of venture capital, 17.5% in leveraged buyouts, which is like a private equity or a form of private equity. 11.75% in foreign equities, 9.5% in real estate, 7.5% in bonds, 4.5% in natural resources, and 2.25% in U.S. equities, public U.S. equities, which is pretty crazy, when you think about the average investor especially in the U.S., is going to have a huge weight board the U.S. stocks. Since Yale has 2.25%.

Ben Felix (00:20:12):
Anyway, that type of allocation where you’re spread across a whole bunch of different asset classes, that is the endowment model. One of the problems, I think for individual investors with the success of Yale and with the adoption broadly speaking across institutions of that endowment model, is that it’s been really hard rather institutions to replicate Yale’s results. Even if they have been able to replicate or at least approximate the process.

Ben Felix (00:20:41):
Again, it comes back to that question of, how do you judge an investment decision, really? Or an investor’s outcome? Do you judge it based on the outcome or do you judge it based on the process. In Swensen’s case other investors trying to follow the same process? I’m not saying Swensen was lucky. I don’t want it to come across that way. I think there’s probably luck involved, but he did pioneer a new way of investing.

Ben Felix (00:21:03):
One of the challenges though is when you start talking about those alternative asset classes, they don’t have as much capacity as public stocks. Capacity is an issue because if everyone says, I want to do what Yale is doing, so they pile into that strategy to absolute return hedge funds. For example, the alpha opportunities start to be spread across more strategies, which decreases the overall alpha that’s available to investors.

Ben Felix (00:21:30):
Theoretically, it’s not a model of everybody can follow and when everyone started trying to follow it, I think it caused some issues. A few really good papers that have looked at this, a 2018 paper in the journal of investing all the grand experiment, and this was looking at state and municipal pension funds because they did a similar thing. They piled into alternative asset classes. In this paper, they suggest the reason was the 2008 decline in pension funds.

Ben Felix (00:21:58):
All of a sudden they had this big reduction in their assets but they still have all of their pension liabilities, so it’s like, okay, what do we do? How do we fund the shortfall? The suggestion in the paper is that they saw alternatives as this opportunity to increase their expected returns without necessarily increasing risk. It sounds pretty good and it worked for Swensen so let’s do it.

Ben Felix (00:22:17):
And the question that this paper is asking is how did that work out for them after they did the big reallocation into alternatives? They found that states municipalities did not get lower risk, they did not get higher returns. They ended up with higher fees and so their conclusion in the paper is that the grand experiment has fallen short of its objectives. There’s another really good paper that looks at, instead of state municipal pension funds, they look at educational endowments, which is where obviously Swensen made his name.

Ben Felix (00:22:47):
But it’s actually pretty crazy. If you look at the Ivy league, endowment funds, their allocations to alternatives are massive. And the larger the university… There’s a report that comes out every year called the, it’s the NACUBO report. It’s an association that they all report to voluntarily and can see what their allocations are, you can see what their returns have been.

Ben Felix (00:23:06):
If you look at those educational endowments, I think on average they have 58%. The largest endowments have 58% on average in alternative investments, a lot. They pay a lot in fees. That’s one of the things that I don’t know if I’ve emphasized enough. When you start getting into alternatives, your fees are going to be a lot higher than if you’re just using public stocks once. 2020 paper in The Journal of Portfolio Management that looked at for the educational endowments. They actually looked at pension funds too.

Ben Felix (00:23:36):
They tried to look at how they’d done, but not just how they’d done, how else could they have done if they just used public stocks and bonds, which again are cheaper to implement. They actually found in this paper that the performance of the endowment funds and the pension funds would have been perfectly replicated using indexes of stocks and bonds, except that they underperformed.

Ben Felix (00:24:01):
Because of all the alternatives and the higher fees, the pension funds trailed the market by 1% and endowments by 1.6%, which just reflects the higher fees that they’re paying for the alternatives. It’s, again, one of those things where we can look at Swensen and say, wow, he did something really special and he created a model that a lot of other people wanted to follow. But if you ask, how good is that model? Really out of sample, out of the Swensen sample and it hasn’t been so good.

Ben Felix (00:24:29):
Again, if we relate that back to individual investors, should you try and replicate what Swensen has done or did? I would probably say no. Even the largest institutions that are trying to replicate what he was able to accomplish have not been able to do so. Now, one of the real big issues here is that in a sales pitch, someone that’s sitting down with a high net worth investor, it’s really easy to have this appeal to authority and say, well look, here’s what David Swensen did at Yale. Because you’re wealthy, you sir, sitting across the table from me or man, you should also be doing this because you also have a lot of wealth.

Ben Felix (00:25:09):
It’s not a good argument, and appeal to authority is never a good argument to do something. Again, if we look out of sample, how has this approach to investing none? Not so good. The other piece that I find really interesting in this whole conversation is that the largest institution, or it’s a sovereign wealth fund, but the largest institutional investor in the world is Norway’s sovereign wealth fund.

Ben Felix (00:25:31):
If you look at it, it looks a lot more like they did mostly on public stocks and bonds and it’s basically a giant index fund. But if you want to make an appeal to authority and ask yourself, “What does the biggest institution in the world do?” Well, they don’t do… This one’s a model.

Robert Leonard (00:25:46):
There’s a lot of talk around and curiosity about what’s going to happen to Berkshire Hathaway after Buffett and Munger are gone. You mentioned Swensen’s unfortunately no longer with us. How do you think Yale’s endowment is going to continue on after Swensen? You mentioned Swensen’s had great results, but a lot of other pension funds and endowments have struggled to replicate it. Without Swensen there, is Yale even going to be able to be what Yale used to be?

Ben Felix (00:26:13):
I’ve got a bit of a relationship with Ted side. He’s got the Capital Allocators Podcast. He was on podcasts. That’s how I know Ted. Ted was close with David Swensen because his first job or one of his first jobs was working with him. Talking to Ted about Swensen, one of the things that you learn is that his ability to pick managers and all that stuff is exceptional, no doubt there, but his biggest skill was the ability to get everybody to buy into the strategy. His ability to communicate to stakeholders.

Ben Felix (00:26:48):
Because think about, he’s managing this endowment fund for this university that’s got real implications for a bunch of people and there are a lot of people relying on him. His greatest skill, as I understand, it was taking the investment concepts and the thesis of what they were doing inside of the endowment fund, and communicating it to stakeholders in a way that got enough buy-in for them to stick with the strategy.

Ben Felix (00:27:09):
One of the worst things that institutional investors do is fire losing managers. We’re going to talk more about that in one of the other questions that I know you want to talk about. One of the worst things that they do is fire losing managers and higher winning managers. A good manager loses for the last three years, they get fired by many institutions, and there’s been research on this. This is what happens on average. And they go and instead invest in managing this one for the last three years.

Ben Felix (00:27:36):
That strategy really doesn’t work very well. Sticking with whatever you’re doing I think is really important and Swensen’s ability to get everybody on board with that was exceptional. With them gone, can they continue to do that? Who knows? I have no idea. Maybe they can continue following the same process. Maybe there are predecessors in place that can continue executing on the strategy, but it’s difficult to say.

Ben Felix (00:27:59):
If we think more generally about active management, reliance on an individual is one of the biggest. If we truly believe that a person is skilled in excess of what can be replicated through processes, then their passing or departure and be a big hit to the ability to execute.

Robert Leonard (00:28:19):
Back in the ’90s and early 2000s, we didn’t have access to information like we do today so it was hard to replicate other super investors. You could do it. You could find filings from Buffett and other managers, but it was a lot harder than it is today. Today you can just quickly in five minutes or less, you could pull up the entire portfolio for the super managers and it’s really easy to try and copy them.

Robert Leonard (00:28:41):
We just talked about how it’s not really replicable for other pension funds, endowments, even individual investors to copy what Swensen’s doing. But let’s take that down to an individual fund manager or stock picker like Buffett or another type of mutual fund manager. Talk to us about why it’s not a great strategy to just copy them blindly and why it doesn’t typically end well for individual investors.

Ben Felix (00:29:04):
Well, you can copy a fund manager or you can invest in their fund. Either way, you’re getting their picks. Again, I come back to outcomes. There have been a lot of cases of outcome-driven decisions by investors when you look in historical data. The high-flying fund managers are nothing new, really. It was in the 1960s is when Fidelity launched their first aggressive growth mutual fund. And so you know, that’s the first time that investors could on mass go and access the picks of a fund manager through a fund that they were managing.

Ben Felix (00:29:37):
We think back to that time. Think back, I wasn’t alive then, and probably most people listening were not either. But if you look at the history books back, then take it in like 1958, technology companies were skyrocketing in price. We had like IBM, there was Texas Instruments, and they were just dominating the headlines, dominating the stock market in terms of market cap.

Ben Felix (00:29:59):
There were lots of electronic companies at the time that were going public and seeing their prices skyrocket. It sounds a lot like last year and this year if you think about it. Really similar actually. New technologies are coming out and it’s changing the way that the world is working and all these companies that went public and prices are going crazy.

Ben Felix (00:30:19):
That’s 1958. That really started by 1968. Stock prices in the U.S. just measured by the Shiller cyclically adjusted price-to-earnings ratio. They’re reaching levels that, it was in ’68, they hadn’t been seen, valuations that haven’t been seen since 1929, proceeding the big crash, and those valuations wouldn’t be seen again until 1995. When we started to have the internet, boom. Pretty crazy. Seriously, high evaluations in 1968.

Ben Felix (00:30:48):
This is when approximately Fidelity is launching their Fidelity Capital Fund. It was managed by Gerald Tsai Jr., a 29-year-old guy. Again, you think about it, it’s interesting to look at what was happening then and overlay it on what the world looks like today and what’s been happening. I made a video on this, last year. I think I made it. I didn’t name any fund managers, but everyone speculated that it was really about Cathy Wood. Her outcome certainly inspired me to create the video. It wasn’t necessarily about her. Because the story is not about her. The stories happen many times before.

Ben Felix (00:31:22):
Anyway, so there’s this guy, a 29-year-old guy’s managing this fund and he’s killing it. He’s hiding his buys, he’s getting it out of the market, he’s not buying hold but he’s basically a momentum investor. That concept didn’t exist back then but what he was doing was being a momentum investor with individual stocks.

Ben Felix (00:31:40):
Then again, it’s companies like Polaroid, Xerox, LTV, which didn’t last too long. He crushed it for seven years. Seven years. The whole time investors are looking at this guy like, can’t lose, crazy, you got to get into the fund. And so the assets that he was managing just grew and grew and grew. Eventually, after seven years he decides to leave Fidelity and start his own fund. This is like he’s got seven years of seriously impressive track record and he starts the Manhattan Fund in 1966, and he raised $247 million in 1966. At the time it was the largest raise for a fund that had happened to up to that date.

Ben Felix (00:32:19):
Starts off [with] 39% return in the first year. Pretty good. But then stopped doing so well and actually went on to be one of the worst-performing funds in history. Now, one of the things that is really important here is thinking about when did investors get in? When he raised the Manhattan Fund after his seven-year streak of really, really good performance, that’s when most of the dollars arrive.

Ben Felix (00:32:43):
Nobody really notices a fund manager that has one good year. Maybe they notice a bit. But seven years, everyone’s, okay. It’s obvious, you got to get in. He’s going to keep crushing it. But then when everybody does get in, the crushing stops. Bad outcome with the Manhattan Fund. I think an investor, if you’d stuck with the Manhattan Fund from the beginning over the next eight years, it lost 70%, or you as the investor lost 70% of your value, so not so good. Definitely was not able to repeat his previous seven years of success.

Ben Felix (00:33:14):
Around that same time, there was another one, a guy named Fred Carr, and he had the Enterprise Fund. Similar-ish idea, but he was investing in emerging growth stocks. He invested in Kentucky Fried Chicken, Tonka, [which] were some of the big ones before they became household names. One of the things when I was doing research on this guy that came up. That it’s funny. It’s interesting.

Ben Felix (00:33:38):
He had a TV in his bathroom. He was on the West Coast, so the market opens, he’s still getting ready in the morning because he’s on the West Coast. He’s got a TV in his bathroom so he can get up to date on what’s happening while he’s getting ready for work. I just thought this isn’t the ’60s. Crazy. He delivered from ’61 to ’66, 17% per year, doubling the return of the U.S. market over that period. Pretty good. Pretty good.

Ben Felix (00:34:03):
But then in 1967, he’s got a good track record at this point. He’s doubled the market return, but in 1967 he returns 117%, crazy. Then in 1968, he returns 44%. Again, pretty good return. At this point, he manages over a billion dollars. Now again, thinking about the flow of funds for Fred Carr’s fund, most of those assets are arriving after the huge return in ’67 and ’68. Again, we have all these dollars chasing the past returns. 1969, he loses 25%. 1970, he loses 25%, and then he ends up leaving the fund, Fred Carr, the main guy, and the fund is taken over by a different manager with a different strategy and I don’t really know what happened after that?

Ben Felix (00:34:48):
Again, similar to the Tsai story. We can even look here in more recent history. We don’t have to go back to the 1960s to find stories like this. I just think it’s interesting to go back that far and see some examples. But when you fast forward to the ’90s, and again, we’re in a situation where a different type of technology company, like in this case it’s internet companies are starting to explore and their prices are skyrocketing. There are tons of IPOs.

Ben Felix (00:35:11):
It’s very similar to then, to the ’60s, and again, to today. When you think about it, there’re a couple of crazy stories from this period. I’m sure there are many more that I didn’t find when I was doing research on this, but the ones that I did find were crazy. Garrett Van Wagoner had an emerging growth fund that they launched in 1996. Didn’t do much at first. Up 27% in ’96, down 20% and ’97 up 8% in ’98. You wouldn’t notice them. I think prior to that though, he had a pretty good track record managing a small-cap growth fund somewhere else, but anyway.

Ben Felix (00:35:44):
But he’s mandating $189 million in December 1998. ’99, he delivers a 291% return. Huge, that’s crazy, 291%. After he delivers that return, he gets $506 million of new flows from new investors that previously were not in… Well, maybe some of them were previously in the fund, but new dollars they didn’t have before, 506 million. Keeping in mind that he had 189 million before the big return.

Ben Felix (00:36:14):
Most of those dollars, and this part’s crazy. This is recent enough that you can actually go in something like Morningstar and look at the timing of the flows. The most of those $506 million of new funds came in November and December of that year. Literally, after the return has happened, right at the end of the year. Pretty crazy.

Ben Felix (00:36:32):
I think it’s also interesting to think about, Gerald Tsai, I don’t know if I mentioned, he was portrayed in the media. As much as investors perceived him as being cool and doing the rank, the media was portraying him in the same way, and Van Wagoner, same kind of thing. He’s different. He’s in San Francisco, he’s in tune with technology and how the internet is going to change the world.

Ben Felix (00:36:52):
There was even a PBS Frontline episode that I was able to find in 1997, where the viewers were told that no one had the golden touch as much as Von Wagoner, so it’s crazy. It’s like he’s got this big return, the media is gassing him up. After the big return in 1999, he lost 21% in 2000 out. 60% in 2001. Compounding, these are compounding losses. Then another 64% in 2002. That hurts a lot.

Ben Felix (00:37:22):
He actually stuck with the fund until 2008. I think it changed its name at one point, but he was still managing the same fund until 2008. If you would invest $100,000 from inception until his departure in 2008, you would have had as much as $625,000 in August of 2000. That’s wild. By February 2008 of your initial $100,000 investment, you’d have $35,000 left. Pretty bad. But listen to this though, that’s 8% per year that you would have lost on average. Over that same time period, the U.S. market gained more than 8% per year, so that hurts.

Ben Felix (00:37:58):
But most people didn’t invest from inception. Most people invested, like I mentioned before, after he had that big run-up. If you got in after the big year in ’99, which is when most investors in the fund did put their dollars in, you would have lost an annualized almost 25%, 24.87% per year. Your $100,000 would have been worth $9,000. Investing from the peak until his departure. It’s crazy. Realistically, most investors wouldn’t have probably held, I don’t know, you’d have to have a lot of conviction in the manager to hold for that long, but if you did, that’s the… I’ve got one more of these anecdotal examples that I just find is fascinating.

Ben Felix (00:38:36):
This one I love too because the fund is still around. This guy is still in business, he’s still managing a fund and actually had a pretty good year in 2020. This guy’s name is Ryan Jacob Bill. He’s still around, so Ryan if you’re listening, hello. He took over this fund called the Kinetics Internet Fund in December 1997. Returned 196% in ’98, 216% in ’99. And again, these are compounding returns. It’s wild.

Ben Felix (00:39:01):
Of course, as with the other examples, all of the dollars flow in after the big years of returns. His fund went from $22 million in ’98 to 1.2 billion in 1999. Now, some of that increase comes from returns, but more than 700 million of the increase in the fund came from new flows into the fund. But that’s a lot of new dollars coming in after the big returns.

Ben Felix (00:39:22):
He left the Kinetics Fund and started his own fund in 2000 called the Jacob Internet Fund. This is the fund that’s still around and that he’s still managing. You got to feel bad. A lot of it’s bad timing. But he starts the fund in 2000, loses 79%, and then loses 56% in 2001 and another 13% in 2002. If you invest $100,000 in his fund in 2000, it would have been worth 8,000 by the end of 2002. Not so good.

Ben Felix (00:39:50):
Now, the fact that he stuck with it is I think very impressive, and he did return 123% in 2020. But if you bought the fund when he left Kinetics and started his own fund and held it since then, including the big [inaudible] in 2020, you’d have an annualized 3.09% return while the U.S. market delivered 7.04%. Ouch, but got to respect the persistence. Maybe in 10 years, we’re talking about how he’s one of the best managers ever and it was just a rough start, maybe. Who knows? Those are anecdotes.

Ben Felix (00:40:24):
Again, I find them fascinating and I find the similarities between the ’60s, the ’90s, and today to be pretty staggering. But one of the other things that I think is important is to look at broader sets of data and ideally published research, which I have some of… the 2017 paper in The Journal of Portfolio Management titled, does past performance matter in investment manager selection? And they asked, how does performance chasing behavior affect investment returns?

Ben Felix (00:40:49):
What they did, and I briefly referenced this earlier in our conversation, what they did is they built a winner strategy that invests in an equal, weighted portfolio of mutual funds with top decile performance against their prospect as a benchmark for the trailing three years. They set the research up this way based on a different paper that showed empirically that this is how institutions do it.

Ben Felix (00:41:09):
They have this basically three-year cycle where they fire losers and higher winners. This paper is asking, how does that affect performance at least in the universe of a mutual fund. We’ve got a winter strategy that invests in the best-performing funds. They’ve got a median strategy that invests in the 45th to 55th percentile funds, and they’ve got a loser strategy that invests in the worst-performing funds. They rebalance each of these portfolios monthly 36 months, and then they reconstitute them for the next three-year cycle based on the same methodology.

Ben Felix (00:41:38):
The results, they’re crazy. They found that the average of benchmark adjusted return for the loser strategy. This is investing in the worst performing funds for the previous period. The losing strategy beats the winner strategy by 2.28% per year and it beats the median strategy by 1.32% per year. By investing in the worst performing funds, you beat the best performing funds by 2.28% per year in their analysis.

Ben Felix (00:42:05):
They looked at this on just a pure returns basis, but they also looked at the sharp ratios, they looked at CAPM alpha. That’s like excess risk-adjusted returns. They looked at Carhart’s four-factor alpha, and I know we’ll talk about factors in a bit, so that might make more sense in a second, but it’s basically adjusting for multiple risks, not just market risk, and seeing what the excess risk-adjusted return looks like. And the loser strategy outperforms on all of those different performance metrics. It’s like that’s pretty crazy.

Ben Felix (00:42:34):
On average, we talked about some extreme anecdotes, which I think are interesting and useful for people to think about, but maybe not that meaningful in terms of making a decision. But now we’re talking about a strategy that looks at all of the funds in the U.S. market, all the mutual funds and picks winners or losers. If you pick the winners on average, you’re losing. The anecdotes I guess were backed up by that aggregated data.

Ben Felix (00:42:58):
I just want to briefly touch on some of the reasons why this might happen. There’s a 2016 paper, Does Scale Impact Skill? They find that the size of the fund increases. I think Buffett’s talked about this too. As the size of the fund increases, it becomes increasingly difficult for the manager to generate alpha. This paper finds that for an average fund and the cross-section that doubles its size in one year. Its alpha drops by around 20 basis points per year. Pretty significant. There’s a theoretical paper that tries to explain why this might be happening or one of the reasons that it might be happening. The 2005 paper. It’s one of my favorite finance papers, I think.

Ben Felix (00:43:36):
That’s known as the Burke Green Paper, it’s by Jonathan Burke and Richard Green. That’s titled Mutual Fund Flows in Performance and Rational Markets. They propose this rational equilibrium model, where there’s dispersion in active manager skill. Some managers are skilled, some managers are unskilled, and investors are competing to allocate their capital to the most skilled managers. In their model, active managers have decreasing returns to scale.

Ben Felix (00:44:02):
If you think about it, in their model, investors are going to… And it’s a reflection of reality as we’ve just talked about. Investors are going to supply more capital to managers who have delivered a good performance. No surprise there. But when they do that, they drive down the ability of those managers to generate excess returns because of the fund’s increasing size and they’re decreasing returns to scale.

Ben Felix (00:44:24):
Now, so in their model, and this is the part that’s just fascinating when you think about it, in their model, investors don’t benefit from the skill of managers. But managers benefit tremendously from their own skill because a more skilled manager has more capacity to absorb assets before the benefits of their skill are diminished. The capacity issue on the managers’ end where their skill allows them to manage more assets before investors start to say, “Hey, you’re not actually generating good performance anymore.”

Ben Felix (00:44:54):
From that perspective, skilled managers don’t benefit investors but they benefit themselves by having a greater capacity to manage assets, which of course they’re charging fees on. Even if you can find a skilled manager, I guess the trick is investing in them before everybody else realizes that they’re skilled, which makes it even more challenging to execute.

Robert Leonard (00:45:16):
And then get out when everybody else realizes it. When all that other money flows in?

Ben Felix (00:45:21):
That’s exactly right. Because when all that money flows in, when everybody’s in there and if skill is zero, you don’t necessarily expect negative returns. Although we saw in some of the examples that that’s what you get. But you’d expect just a random outcome. Not necessarily good or bad. One of the other issues in there that I didn’t touch on is that in those anecdotes we talked about at the beginning of this piece, in all of those cases, the managers were probably getting lucky. Maybe they were really smart. I’m sure they are really smart people. None of this is a knock on the intelligence of managers. It’s just a very competitive thing that they’re trying to accomplish.

Ben Felix (00:45:55):
But the other thing with those anecdotes, and it could be true more generally. I don’t know if I’ve seen research on this. But in those anecdotes they were investing in high-flying, high-priced companies. And if we just separate that out and forget about the managers for a sec, and just think about how have investors done when they’ve invested in the highest priced companies in the market, they’ve done really badly.

Ben Felix (00:46:19):
Investing in growth stocks on average underperforms the market, it under-performs investing in value stocks. And this is talking about investing in the most extreme growth stocks in those examples that we gave. So from that perspective, unless the manager’s exceptionally skilled, there shouldn’t be any surprise that they’re underperforming in the end.

Robert Leonard (00:46:37):
As you were talking about Ryan Jacob, I hadn’t heard of him, so I did a quick Google search. And the first thing that comes up is actually really fascinating to me because it says Ryan is the chief portfolio manager for the Jacob Forward ETF since the inception in 2021. I think that’s fascinating because that’s the first thing that comes up. But you just told us a story from the ’90s and early 2000s of how this guy has been managing money from all the way back then. But the first thing you Google in his name is, oh, since the inception of 2021. And there’s this survivorship bias, I think that’s perfectly illustrated with that, people don’t even think about.

Ben Felix (00:47:16):
I got to say, I know I’m using him as an example of why chasing fund managers is not a good thing to do. But I seriously respect the fact that he’s been doing this since then and that he’s lived through that and he’s still managing a similar strategy. That’s impressive, truly.

Robert Leonard (00:47:32):
Well, the third link down says, “Fund Manager Ryan Jacob takes on Cathie Wood’s ARK Fund.” It’s interesting, it’s really interesting. To talk about the size, you mentioned Buffett, he does. He has a quote that says, “If he had a million-dollar fund, he guarantees that he could return 50% a year, every year with that size fund. That just illustrates that size really is a limiting piece. But I think the other piece too, is these funds have a lot of…

Robert Leonard (00:47:57):
We talked about the inflows and how the size hurts but there’s also the outflows. When things start to struggle, managers are forced to sell out of positions that maybe have gone on to do great things. But because they were forced to sell, that hurts as well. There’s a lot of these negative features of funds that they have to deal with that we don’t have to as individual managers.

Ben Felix (00:48:16):
That’s a good point. In the Fred Carr example, they had a lot of issues and it makes me think a little bit about Cathie Wood too. They had a lot of issues where they were the largest holders of small companies. When they did start to have outflows, the negative returns were exacerbated by the fact that they had to sell this relatively illiquid position. That’s definitely valid, I agree.

Robert Leonard (00:48:38):
A very common piece of advice or strategy that I’ve heard people talking about lately. And it’s mostly in the FIRE community, which is Financial Independence, Retire Early for those who don’t know. Totes buying high-dividend-yielding stocks as a great strategy. Walk us through the potential pitfalls and dangers of investing in high-dividend-yielding stocks, outside of just individual stock picking being difficult in and of itself?

Ben Felix (00:49:04):
Okay. I don’t even think I have to pick on dividend investing at least to start, to answer the question. We think about value investing, just low price stock. When you say high yield, another way of saying high yield is low price. Because if you take dividends hold them constant, a lower-priced dividend stock with the same dollar dividend is going to have a higher yield. So I think high yield is another way of saying low priced in the case of high yield. We’re just focusing only on dividends which have its own problems, which I’ll probably touch on as well. Now, if we just use value investing for a second and forget about the dividend filter.

Ben Felix (00:49:42):
But the problem with looking at prices or yields doesn’t matter. We can talk with there’s somewhat interchangeable. If you just look at the lowest price stocks, you’re getting one or two things. And it’s really hard to know which one of the two things that you’re getting. You’re either getting a high discount rate, and I’ll back up for a second. If you’re buying a stock, you’re buying discounted future cash flows, fundamentally that is what you’re purchasing.

Ben Felix (00:50:08):
If you’re paying a low price for a stock, you’re either paying a low price based on a high discount rate, meaning that it’s a very risky stock. Which is not necessarily a bad thing. You might even look for stocks with the highest discount rates because you want higher expected returns. But the problem with just looking at prices is that you might be getting stocks at high discount rates, or you might be getting stocks with low expected cash flows. They really want to buy the stocks’ low expected cash flows.

Ben Felix (00:50:33):
It’s really hard to say if you’re just looking at price or just looking at dividend yield, it’s really hard to say if you’re buying something with a high discount rate, which maybe isn’t so bad or if you’re just buying a junk stock. Literally just a bad company. And it’s got a low price because it’s not going to produce future cash flows and you, therefore, don’t really want to own it. So whether we’re talking about high yield or value only, I think that’s a major problem.

Ben Felix (00:50:58):
One of the ways to deal with this, and this is something that Buffett very impressively pioneered before anybody else knew to do it. And before the academic literature had figured this out, which is recent. It’s in the last… We’re in 2021, maybe the last 10 years or so where this idea of quality investing or controlling for profitability, which is something that Buffett was doing for a long time. It’s only recently that Academia has said, “Hey, look at this profitability thing or this quality thing. If we control for that, it fixes the problem with value.”

Ben Felix (00:51:34):
Because if you control for cash flows, if you say, let’s just find companies that we know have strong cash flows, and you can do that by looking at one example, gross profitability. If you take gross profitability, it ends up being actually a pretty good predictor of future profitability. A company that’s currently profitable tends to continue to be profitable. If we just take those companies and then sort them by price, now you’ve got low price companies that we know have strong cash flows.

Ben Felix (00:51:58):
So you’ve got a much better idea that you’re picking companies with a high discount rate and their prices are low because of that rather than their prices being low, because they’ve got weak profitability. So we use with my firm, we generally take the approach of index investing, but we have some filters in place for low prices and for robust profitability and then a couple of other things.

Ben Felix (00:52:19):
We don’t call it quality. Other companies like MSEI have quality indexes, and they’re doing something very similar. They’re just looking at different metrics. They’re using a combination of return and equity leverage and earnings variability. But it’s getting to the same generally speaking place where we’re saying let’s control for the quality of the company so that we’re not buying cheap stocks because they’re junk. We’re buying cheap stocks because they’ve got high discount rates and therefore higher expected returns, which is good.

Ben Felix (00:52:47):
To speak to dividend stocks. Dividends are not returns. And I think that’s something that is often a challenge for people who have abided by the philosophy of dividend investing. When you receive a dividend, your capital has to reduce by the amount of the dividend that’s distributed to you. Now people are going to say, “Well, no, I own dividend stocks and I get dividends and the price doesn’t go down by the same amount.” Of course, it doesn’t. But that’s because there are massive amounts of noise in prices every day.

Ben Felix (00:53:13):
If you watch the accountants say, “Oh, well I got a dividend and the price went up.” That doesn’t mean that what I just said, isn’t true. When a company distributes cash, the value of its capital is reducing by the amount that it distributed. So on dividend distribution, you’re getting a net-zero. All else equal holding all of this constant, you’re getting a net-zero return before tax and you might be paying tax on the dividend which makes it even worse.

Ben Felix (00:53:36):
Now, there’s a whole other problem with dividends. We talked about profitability. We want to control for profitability. If we’re going to invest in low price stocks, some people might’ve been listening to that and saying, “Okay, if I’m investing in high yield, the dividends are telling me something about profitability.” Well, I am doing that. I’m controlling for profitability by looking at high dividends. The challenge with that is that a dividend can be faked. And I don’t mean faked in the sense that you’re not getting real cash, but it can be faked in the sense that the cash that you’re receiving as a dividend is not reflective of underlying profitability.

Ben Felix (00:54:14):
Now I know people who are well-versed in dividend investing, they are looking at stuff like this. They are looking at payer ratios and growth rates and profitability and reinvestment and all that stuff. If you’re looking at all that stuff, great. I don’t think you need to constrain yourself to only dividend companies. I want to walk through a quick example though. There’s this theory of dividend irrelevance. I know a lot of people that believe in dividend investing are going to be shaking their heads saying that the theory is BS.

Ben Felix (00:54:40):
Like any theory, it’s not a perfect reflection of reality. I think it’s a useful model. And I’m just going to talk through why I think it’s a useful model. Valuation is what drives stock returns. If you buy cheap company, if you buy cheap cash flows, you’ve got higher expected returns. That’s a truth in the market unless you’re investing in game stock. And we’ll talk maybe about that later.

Ben Felix (00:55:02):
So in this 1961 paper, Miller and Modigliani, they introduced this concept of dividend irrelevance. Their objective in the paper was to show that from a theoretical perspective, investors should not be concerned with dividend policy given investment policy, and that’s important. If you know what investments a company wants to make then dividend policy is irrelevant to the valuation of such shares. Today, there are ways to estimate future investment. It turns out that last year’s growth in assets is a pretty good predictor of next year’s growth in assets. So we don’t know…

Ben Felix (00:55:34):
We don’t have perfect foresight on investment policy but we have a pretty good proxy for it. Given investment policy and this is the important part. Given investment policy, dividend policy becomes a financing decision. I’m going to talk through an example that hopefully helps people see why what I meant by dividends potentially being fake. You have profits, you can use profits to pay dividends, or you can use profits to invest in projects. You can do either one.

Ben Felix (00:55:59):
If profits are used to pay dividends, given the plan to invest in projects. Remember we said holding investment policy constant. The capital for the projects that you want to complete will need to be raised by other means. In my example, I’m going to use the issuance of new shares. So based on the dividend policy, given investment policy is a financing decision. And from the perspective of the investor in the best company, the financing decision at the corporate level just implies a change in the distribution of how you’re receiving your total return.

Ben Felix (00:56:31):
If we take Sample Co. Got $200,000 in cash, they’ve got $800,000 in assets at market value, and they’ve got no debt. 100,000 shares outstanding in my example, so each share is worth $10. They’ve got investment opportunities, but they also know that their investors want to receive their usual $2 dividend. So they pay it, they pay the dividend. They spend their $200,000 of cash from their profits from the previous year. And then they raise $200,000 in new equity to finance the investments that they had planned to make. So given investment policy.

Ben Felix (00:57:05):
The newly issued shares, they’re going to dilute the ownership of the future profits for the previous shareholders, but the holders of the previous shares, they also receive the dividend, compensating them for the diluted value. So if you’re a shareholder of this stock before the dividend was paid, you have $2 in cash from your dividend. And you’ve got an $8 share because the dividend has to reduce the amount of capital that you have. And the new shares needed to raise the $200,000 of capital for investment are issued at $8 per share, based on the new lower valuation. After the dividend was distributed to the 25,000 new shares issued.

Ben Felix (00:57:41):
This company is now paid a dividend, it’s got $200,000 of cash to invest. It’s got $800,000 in assets at market value and it’s got no debt. And they’re 125,000 shares outstanding instead of the original 100,000. The value per share has dropped $8 after the dividend was paid. Now the company looks exactly the same. And as the shareholder, if you owned four shares in the company, your ownership of its feature profits has dropped because there was a dilution from the equity issuance. But you could take your $8 in dividends that you received and purchase another share, which takes your ownership of future profits back to its previous level.

Ben Felix (00:58:13):
Now, another thing I know dividend investors believe is that you the investor are better at allocating your capital than the company. And therefore you might want to take those dividends that you received and invest in something else. Sure. Valid, fine. But in my example, you reinvest them in the company or you could choose to reinvest in the company, I guess. Now, if they had not paid that dividend and just finance the project internally with the profits, instead of paying the dividend, you the investor would have received no dividends. You would have been left with four shares, valued at $10 each and your entitlement of future profits would have remained sane.

Ben Felix (00:58:49):
In both cases, the investor ends up in the exact same place. It’s just different… How their total return was distributed to them is a little bit different but the return is the same. So whether the company paid a dividend or not, it didn’t actually matter to the expected return. Now, if we look at the current theory in asset pricing, valuation theory suggests that discounted profits, the discounted value of expected profits minus expected investment is how people value shares. And there’s lots of literature on that.

Ben Felix (00:59:21):
We can estimate both. We can estimate gross profitability. Like I mentioned before, we can estimate the expected investment using the current book value of assets. What I would argue is that investors looking for higher expected returns, rather than looking at high dividend-yielding stocks, they should be looking at companies with robust profitability that invest conservatively and trade at a low valuation. You might get there using high-dividend stocks, but you’re going to end up with a more concentrated portfolio.

Ben Felix (00:59:52):
And you might end up with companies that don’t actually have robust profitability. They just look like they do because they’re paying dividends. But if you just build directly to the source and say, give me profitable companies that invest conservatively and have low prices, that to me makes a lot more sense than the, maybe get partway they’re using a high-dividend-yield, but it’s not going to be as reliable.

Robert Leonard (01:00:13):
One of the things that I’ve been fascinated with lately is how successful people and great thinkers like yourself think and learn. It can be a bit meta, but I love learning about how to learn and how to learn the right way. Break down what the Feynman Technique is? And then also give us insight on how you personally learn? Clearly, you know a lot about all these different topics we’ve talked about today. I want to know how, if you didn’t know something, how are you going about learning it? And then also break down the Feynman Technique for us.

Ben Felix (01:00:44):
I’m going to be honest. I had to Google the Feynman Technique when I saw you wanted to talk about it. But I did, I googled it. And there are a few different iterations of how people interpreted it. I would summarize it as… I like it actually when I read it. It resonated with me. You choose a topic to learn and you learn everything that you possibly can about it, through reading and whatever other means. And then you teach it to someone else who has no baseline knowledge of the topic. And then when I googled this, some of the people said, “Teach it to someone at a sixth-grade level.” Other people said…I think Feynman himself said, “If you can’t teach to a freshman, you don’t understand anyway.” Teach it to someone who doesn’t have a baseline knowledge of the topic that you’re trying to learn about.

Ben Felix (01:01:22):
Through explaining it to them. You’re going to identify gaps in your own explanation. Because if you can’t explain it to the sixth-grader or the freshmen then you don’t understand it yourself. So you go back to the source material, fill in the gaps, simplify your explanation and repeat that process. Now I mentioned, I really like this when I read it. I guess thank you for teaching me this or telling me that it existed. I think I had heard about it before, but I’d never taken the time to read what it was all about. Now it resonated with me, I think because it’s pretty similar to what I do when I want to learn about something.

Ben Felix (01:01:53):
So for all of those topics that we just talked about, those are all things that at a point in time I didn’t know anything about. But I want to make YouTube videos. And on my podcast, I’ve got to have things to talk about that are, well things that I haven’t talked about previously. So I have to go and learn new stuff. So what I do, I end up with a ton of browser tabs open on my computer, just an embarrassing amount. Usually a few books. I only have two books on my desk right now, but if I’m going deep in a topic, I’ll sometimes have a stack of four or five books with speaking notes [inaudible 01:02:23] in folded pages and all that stuff.

Ben Felix (01:02:25):
And then podcast episodes are another big one. So in many cases, what I’ll do is we’ll take those books that I’m reading and I’ll find five podcast episodes that author has done covering those topics. And I’ll listen to those and then go back and read sections of the book again that I didn’t fully understand the first time. The other thing that’s a little bit unique and you can probably relate to this Robert is that I’m lucky in the sense that if I’m reading a book and I’m really interested in the topic, but maybe something’s not quite sticking or I’m missing something.

Ben Felix (01:02:54):
What I’ll often end up doing is contact amendments saying, “Hey, listen, I have this podcast and this many people listened to it, would you be interested in coming on?” And most of the time, at least in my experience, people are more than happy to. And so any of those questions that I still have that I haven’t been able to figure out from reading their stuff or listening to other podcasts, I just get to ask them, which is a privilege, I think. It does help a lot in the process.

Ben Felix (01:03:16):
So I’ll sit with that information for like… Depending on the topic. If it’s about valuation or active managers, stuff like that is not so hard. But one of the other times that I was on your podcast, we talked about quantitative easing, which when I started diving into was like, that was new ground for me. It was way outside of most of the stuff that I had learned previously. I did CFA, which has some economics in it but nothing like that. So for that one, I think it was two months that I was just like in books and podcasts and talking to people who were experts on that.

Ben Felix (01:03:47):
I think we actually had three or four podcast guests in those two months that were invited on because I was trying to figure that topic out. They had various levels of expertise on the stuff I was trying to figure out. So anyway, I do all that learning. And then I try to write about it before I do a video or a podcast episode, I always write it. I write down my notes and once I’ve done that, I’ll usually try and cut down fluff and stuff that doesn’t really matter. Until it gets to a point where I can read it and feel other people will probably understand it.

Ben Felix (01:04:19):
But I always think back to my… When I finished university with my engineering degree and I literally knew nothing about finance or investment or anything. I try to think back to that guy, would he understand this? And that’s one of the benchmarks that I use. And again, this is a privilege, and my ability to learn all releases it as a podcast episode or a YouTube video. Lately, it’s been more podcast episodes because there are a lot less work than YouTube videos. But either way, I take my understanding of this topic and I just give it out to the world and comments and questions that I get from people. That is probably at least as a finishing touch to learn a topic. That is where any remaining gaps are filled in.

Ben Felix (01:05:03):
And it’s a pretty exciting experience because it’s like, there are so many things that, okay, I read four books, listened to all these podcasts and whatever, whatever. And then someone asks a question it’s like, wow, I didn’t think of that. And that really fills in the gaps. So it’s like crowdsourcing, filling in little gaps that you didn’t previously understand. So anyway, when I read the Feynman Technique, it was a lot, like what I do anyway. So I guess that’s why it resonated with me.

Robert Leonard (01:05:32):
It’s almost the exact same for me. Except I recently made the transition from physical books to eBooks. So I just whip up my iPad and start reading there. I’m a huge fan of physical books. I have like 300 plus downstairs at my little personal library, but I’ve been really, really, really liking Kindles lately, eBooks. That’s the only change that I have that I think is a little bit different from our processes. But other than that, more or less the exact same now. I’m curious, do you read the books cover to cover, or do you go and look for specific information?

Ben Felix (01:06:01):
It depends on the topic. If it’s something that I know a lot about already, then I’ll skip to the specific section that I’m trying to learn about. But I use quantitative easing as the example because that was like… personally, that was, is a big thing. I think back in my life, hard things that I’ve done. When I was playing NCAA basketball. Training and getting up in the morning and all that stuff. That was a hard thing. Doing the CFA when I was working full time, that was a hard thing. It sounds ridiculous to say it, but learning about quantitative easing, to the extent that I could speak about it. That was a really hard thing.

Ben Felix (01:06:34):
So when I did QE because it was something that I didn’t know much about. If I had a book on that I was reading a cover to cover because there were so many little details that I just didn’t know about it. It’s crazy how the gaps slowly fill in. That’s one of the things about learning, that I think is important for people to understand is that it’s painful. I just talked about that process and it maybe sounds fun and exciting or whatever but it’s uncomfortable. Our bodies are not programmed to sit down and learn. And we are programmed to conserve the condiment idea of system one and system two brain. And your system one is the automatic thinking, your system two is when you really sit down and turn your brain on and engage it.

Ben Felix (01:07:12):
We’re designed to avoid engaging our system to brains. Because it uses way more energy than system one. But to sit down to learn a new thing, it’s evolutionarily something that we’re not really geared to do. And I feel it. It’s stressful, uncomfortable. I’d rather be doing other stuff. The outcomes are nice. Knowing about stuff is cool. Being able to talk about stuff, especially when people are going to listen and give feedback, that’s cool. The learning is not comfortable. I mentioned CFA that finishing was amazing. Finishing level three of CFA we felt so good. But the three years that I was… Lived in a small apartment then, so I’d be in coffee shops or in my office until 9:00 PM or whatever. That was awful. That was one of the worst experiences of my life

Robert Leonard (01:07:59):
Going to you’re all those quantitative easing books. Did you find any that stood out? If somebody is listening and he’s like, “Oh, I want to… He or she is like, I really want to learn about quantitative easing, clearly Ben spent a lot of time reading it. What books should I read?” Is there any of that really stuck out to you?

Ben Felix (01:08:13):
So Cullen Roche has a book, Pragmatic Capitalism is the title of his book. He’s also got a paper though, and the paper might even be better than the book because the book covers other subjects as well. I think the paper is just called Understanding the Modern Monetary System. He takes a very practical approach. One of the challenges, when you start trying to learn about quantitative easing, is that a lot of the research is from autonomists at the fed or monetary economists that are using a very technical language. And they’re talking about everything in theoretical terms.

Ben Felix (01:08:43):
But one of the things that was great about Cullen’s stuff is he takes, well, I guess like the book suggests he takes a very pragmatic practical approach to what’s actually happening. And he talks about, I think it was, it might’ve been even been on the, We Study Billionaires podcast that I heard call and talk about this. But his experience was that he had a friend whose dad, or maybe it was with a friend itself, I can’t remember.

Ben Felix (01:09:03):
So he knew somebody that was at Japan Central Bank and they’d been doing QE for a long time. And so Cullen called them up and it’s just like, “What’s actually going on here?” And they were able to talk them through what was happening and for him that made the practical aspects a lot easier to understand. And then when you read his stuff, it’s like, okay, that’s what’s actually happening here. And Cullen’s big thing was calling the fact that there wouldn’t be inflation when QE is happening after 2008.

Ben Felix (01:09:28):
And everyone was panicking about inflation. And Cullen’s like, “No, no, no, here’s, what’s actually happening and this is why we shouldn’t expect inflation.” And we didn’t get it. Anyway, so that was a bit of a win for him, but also to his way of thinking. And then there’s a woman named Frances Coppola. She’s in the UK I believe. Similarly, she has experience working in banks.

Ben Felix (01:09:50):
And then she’s also got a lot of theoretical economics knowledge. And between those two things, she’s able to communicate. Again, here’s what the economic theory says, but here’s, what’s actually happening. And you take those two things together. She’s got a book called, I think it’s called the People’s QE. She’s arguing for a slightly different approach to QE. But in that argument, she does a really good job of explaining what’s actually happening.

Robert Leonard (01:10:12):
Did your new understanding of QE change, how you viewed Bitcoin? Did you have one opinion of Bitcoin going into QE and then maybe have a different opinion of Bitcoin coming out of QE? And if not, that’s okay. I’m just curious how, if and how that changed?

Ben Felix (01:10:28):
Not really. One of the things, when you start reading about it, it’s not just QE, but just how the monetary system works, is that the quantity of money which is one of the best arguments, most entrenched arguments that I hear for Bitcoin is the fixed supply argument. When you start digging into how the monetary system works, at least my interpretation of it, is you start to understand that having a fixed money supply is not actually a good thing, and it’s not a superior feature of Bitcoin or of gold back. The money supply is a little bit more fluid is not such a bad thing. It’s actually a really good thing. I think the crisis that we just lived through is an example of why it’s a good thing to have some elasticity in the supply of money.

Ben Felix (01:11:08):
I tried recently with someone that I know who’s very much into Bitcoin and has been from the early days, we had a long conversation and we went back and forth over email afterwards. I was really trying to get it. I was really trying to get like this guy’s a smart guy. And I know lots of smart people who are just so entrenched in the idea of a Bitcoin. What I came out of that with as an understanding, and you can tell me if I’m wrong here or if you think I’m wrong. But my understanding from that conversation was that the strongest argument for Bitcoin is the idea that we should be on a fixed supply currency. And if that is going to be the Bitcoin is the best solution to accomplish it.

Ben Felix (01:11:48):
And it’s from a technological perspective, I can’t disagree. I think it is a very elegant technology. The challenge that I have is that I don’t agree with that fundamental piece, which is that we need a fixed supply guarantee. And if you disagree on that, if you say, “Well, no, we don’t actually need that.” Then you shouldn’t expect the value to increase in the way that many of the proponents of Bitcoin believe. What do you think about that?

Robert Leonard (01:12:12):
I think that I don’t understand Bitcoin enough to have arguments for or against it, but I think that I have belief in some of the people that, like the gentleman you spoke to which I don’t know necessarily who it is. But I have people like that in my life as well, that I think are very smart, that are very entrenched in Bitcoin. And I believe in them more than anything. And so I figure, at least having a small allocation for me is worth it. And if it works out great. And if it doesn’t, I had just a very small allocation and I’m okay with that.

Robert Leonard (01:12:42):
And I do have plans to eventually study that more. But in today’s world there are so many different things that we can study. I have so many things that I need to study. I’m in real estate, stocks, building a business Bitcoin it’s like, which rabbit hole do I fall down? And I just haven’t gotten to the Bitcoin rabbit hole yet.

Ben Felix (01:12:57):
The University of Chicago had a panel with… Oh, I’m not going to remember his name. It was David Booth, who was the founder of a huge asset manager. Eugene Fama, who’s like one of the fathers of modern finance. Cliff Asness, who is the… He runs AQR, which is a massive hedge fund firm that does quantitative strategies. All University Chicago people. And then there was Kaplan. I can’t remember his first name, was it Ryan [inaudible 01:13:24]. But one of the things they talked about was Bitcoin.

Ben Felix (01:13:27):
And Cliff Asness who has got a tremendous amount of respect for, he’s done tons of amazing research in financial economics. He said something similar to you where…, and similar to me, too. Where it’s like, he hasn’t gone down the rabbit hole yet to figure it out for himself. And he says, “Full disclosure, this is not a good way to make a decision or to think about something.” But he says, “Based on the people that are involved with it, I wouldn’t touch it.

Robert Leonard (01:13:48):
That’s funny. So he goes the opposite way of me, huh?

Ben Felix (01:13:52):
Yeah, exactly. Same way of making the decision, but opposite conclusion.

Robert Leonard (01:13:57):
That’s interesting. And I do. I guess one of my concerns is that there are people that I do think are very smart, that believe in it, but then I also get concerned that some people are so entrenched in it that they can’t change their mind now. And they have this bias where they fall super victim to confirmation bias. And I’m not saying this is happening to everybody, but I’m just concerned that could be a case for a lot of Bitcoin bowls out there. And so that’s one of the things I’m trying to keep an eye out for. But when I look for people that make arguments against it and people that make arguments for it, I tend to agree, I think a little bit more on the side for it. But again, super small. It’s really the way to manage your risk is position sizing. And so that’s pretty much how I’ve handled it.

Ben Felix (01:14:42):
I said that. I did a video before when Bitcoin is probably at 4,000 or maybe even less. I did a video trying to give an overview of what it is, I said in that video, why I probably wouldn’t invest in it. I said, “If it’s a currency, you don’t invest in currencies because they have zero expected return”. And likewise, if it’s more like gold than, I don’t think gold has a positive expected return either. So I probably wouldn’t touch this thing.

Ben Felix (01:15:04):
But I did say, if you are going to touch it, maybe do a base on capitalization weights, like Bitcoins total capitalization, relative to the stock market and size your position that way… I don’t think it’s crazy to do that. I wouldn’t go all-in on it. I don’t own any, and I don’t plan to. But I think having a small position isn’t crazy at all.

Ben Felix (01:15:22):
There are two economists, Tyler Cowen, who’s got a podcast called Conversations with Tyler and John Cochrane. He’s at the University of Chicago. Can’t remember where John Cochrane is, possibly Stanford. Both are very well-spoken, good communicators. John Cochrane has also got a podcast actually, but it’s not updated regularly. But anyway, they both have really good criticisms of Bitcoin that are worth checking out.

Ben Felix (01:15:46):
And I actually have John Cochran coming up on my podcast in the next few months. And that’s one of the things that I’m most excited to ask him about is why he’s a Bitcoin bear. It’s beyond being a bear. He just thinks it’s silly. I’m very much looking forward to my conversation with him. But both of them have published blog posts on their thoughts, so they’re worth checking out.

Robert Leonard (01:16:09):
I’ll check them both out myself. I’ll put links to them both in the show notes. And I’ll definitely check out your episode with him when it goes live. Really one of the biggest, most loud people that I’ve heard bear against it is Peter Schiff. And when I see his arguments on Twitter, I really just don’t really like it. And I don’t really agree with what he’s saying. I’m not saying I wouldn’t agree with a different bear, but for him, he just seems to be the loudest from what I’ve seen. And so just hasn’t been overly strong yet. But I guess we’ll see and I’ll have to dive a little bit deeper myself and make the decision.

Robert Leonard (01:16:41):
Well, Ben, as always, I’ve really enjoyed our conversation. I’ve learned a lot and I know the audience is going to as well. I think it’s a great idea for everyone listening to follow you. So where is the best place they can go to find you, follow you, learn more from you?

Ben Felix (01:16:56):
Well, I’ve got my Common Sense Investing YouTube channel, but I haven’t been updating it. I need to get back to making videos. I’ve even got in my new house here, I’ve got it. If you can’t see it, it’s out of frame. But I’ve got a little studio set up. I just anyway… So you can follow me there but just, it’s still a little stale right now. I’ve got a podcast called the Rational Reminder, that the YouTube channel is called Common Sense Investing.

Ben Felix (01:17:16):
I’ve got a podcast called the Rational Reminder. That is weekly and it’s been weekly ever since it started. And we have no intentions of stopping that cadence. It is on YouTube with video as well as being on all the podcast platforms. So you can check me out there. That’s where I’m most active right now. And I don’t know Twitter and stuff, but I don’t really tweet so.

Robert Leonard (01:17:34):
I’ll put a link to all the different resources Ben just mentioned for him personally, in the show notes below. I’ll put some links to other stuff that we talked about throughout the show books and other resources you can dive into as well in the show notes below for anybody that’s interested. Ben, thanks so much for joining me.

Ben Felix (01:17:50):
Thanks a lot, Robert. It’s great.

Robert Leonard (01:17:51):
All right guys, that’s all I had for this week’s episode of Millennial Investing. I’ll see you again next week.

Outro (01:17:58):
Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin and every Saturday we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.