It's entirely conceivable that all of this work goes into creating these incredible AI models and all of the value accrues to the consumer and not to the people who create these models. Maybe there's unlimited demand for compute. But it's more the stock market that's demanding it rather than consumers demanding. Ultimately, those multiples do mean revert growth rates, mean revert. If you believe in mean reversion, then the smart bet is small and micro value, mid-cap value. Toby, welcome back to Excess Returns. Excess, much for having me, Justin. I'm excited to be on the premier financial podcast, currently on YouTube. It's our goal. Hopefully we'll get there at some point. We might be top 50, maybe? I don't know how to do it, Justin. We're doing our best. Well, I've been trying to convince Jack to lean into the most bearish covers and titles as possible. And he just, he won't do it. I mean, there's certainly a track the tension. I've noticed that they all sort of trend towards the same stuff burning down on the background and red color. My AI suggests it all the time as the one that you should use. Yeah, we don't use them either, but by the way, Toby, your YouTube thumbnail game has gone up a lot recently. I've been noticing that. Yeah, right. I'm always looking at what all the competitors are doing. You're doing some great work over there. Yeah, I get the AI to suggest some names. And then I run an I betist. It's been good. Toby, we always like having you on at least once or twice a year to get your thoughts on the value, investing landscape, sort of how you're thinking about developments in the market. And just a wide range of topics that I think we're going to cover today. You've been a long-term guest, a friend of the podcast. And I think one of the things that Jack and I always have appreciated about you is you kind of have stayed in your wheelhouse. The message has been consistent ever since we know and you ever since you started running the funds. So, you know, we're looking forward to the conversation with you today to talk to talk that value and a whole bunch of things. You are founder and portfolio manager of acquire funds. And the firm offers two ETS. The acquires fund ticker symbols ZIG and also the acquires small and micro cap deep value ETF ticker symbol deep. You can learn more about these funds on their respective fund websites acquires fund.com and acquire requires deep.com. To start, I think Toby, we I wanted to just kind of get at high level overall sort of market valuation. I think if you look at the market today based on almost every measure, you know, things look either expensive or very expensive. But I think when you hear these things about where the market's at, whether you're looking at the Schiller PE or Tobin's Q or whatever metric you're looking at, you know, you can't just like, you know, say, like get out of the market. That's not like the read on this stuff. So, how do you think about, you know, what these valuation, these these market valuations, what do they tell you, what do they don't and how are they useful for the investor, do you think? Yeah, I think it's it's tempting to look at those market valuations and get scared out of the market. That's that's, and that's a mistake, I think. The market over valuation is really well documented. It's, you know, the advisor perspective's website has they track like six or seven different market level valuation metrics. There's Schiller PE, Tobin's Q, the trend of the market against the long term trend, a few other sort of single year PE metrics and things like that. Every single one of them is and collectively they're they're most overvalued in the data set. The Schiller PE is one that's sort of slightly on the states, the level of over valuation. The others sort of seem to suggest they were in this uniquely expensive time in the market, which if you're a ball on AI and the singularity AI being so completely transformative that it completely changes the way we do business, such that these companies are going to earn super normal returns on capital and they'll never ever be headed by any other business than maybe these multiple to reasonable. If you're in the camp that we sort of have these long term returns to we mean revert back to long term means, which honestly seems like a kind of quaint idea these days because it really hasn't happened for an extended period at home, but that used to be the case like in 100 plus years of data we've always gone back to the average. Then it looks expensive and you look like the Ford returns, the the corollary to over valuation is just reduced Ford returns and often accompanied by a lot of volatility, a lot of crashes and things like that. So on a comparable basis where something like the peak the dot com boom or the very last few months of the dot com boom if you like the Schiller PE because it's not quite a but all time like and there's no reason why the all time highs are ceiling China got to a hundred times Japan got to a hundred times the US getting to 44 times that's not a magic number it could easily go through that number. Having said all of that though we had the same scenario in 2000. Very very expensive market, very bifurcated market where there were a very large number of high quality undervalued stocks trading at reasonable multiple maybe even discounts to reasonable multiples and that was what set up a very good return for the next 1015 is for small and micro cap particularly small micro cap value and quality. I think we're in a similar sort of scenario and I say you don't want to look at those headline numbers and pull out of the market. I think you want to look at those headline numbers and then look for other places where there are reasonable prospects for good forward returns and I think that that deep value small and micro mid cap even quality looks to me like it's got pretty good forward returns from here even assuming that you don't get any mean reversion in the multiples because I think the multiples are small discounts to the long run averages. This is something where it just if they just earn reinvest pay those earnings out to shareholders the shareholder return for that part of the market is so much better than the top end of the market but the growth at the top end of the market is hard to ignore. Actually the hyperscales and mag 7 can turn all that investment into returns and we continue to see this sort of market that continues to concentrate on a handful of firms. Yeah I mean that's the thing it's like what do you think of like right now if you look at where most of the S&P is well it's 35% to 40% of the S&P it's in these very large tech names they're quality companies in a lot of ways but they're also you know they're the ones that are driving most of the market over valuation. Do you think that to some extent maybe the valuation could be sort of justified there because of those and it's sort of interesting like if you think we've talked about this too with you before Tobi we talked about Buffett's you know Apple trade and I think would he bought the stock back in whatever it was 2015-26, I think 2016 you know the PE of Apple was around 10 to 12 times. I mean Apple today is like you know over 30 times trailing earnings so it's just amazing that if you think about a company any like as Apple's growth prospects better today than they were you know 10 years ago I mean I don't know so I don't know there's a lot I think to unpack there. I think there's a couple if you're interested to add small caps about before mag 7 this year and that's a little bit of a narrative violation I don't know if a lot of folks know that last 12 months small caps have up for mags as well I think we're getting close to that point. A couple of things that I like to track, a couple of very long-term ratios that I like to track equal weight S&P 500 versus the S&P 500 market capitalization weight which is the standard one that most people track equal weight is the unusual one. Equal weight has typically outperformed the more regular version of it because small caps tend to perform large caps and for the the data that we have it goes back I think you can get back to 99 do you think there might be the launch of the equal weight ETF. The equal weight has outperformed the market cap weight version of that the entire way through but it has on notable occasions that relationship has reversed where the market cap one outperformed the equal weight one and so the late 1990s.com bubble.com boom 2020 and then it gave back a lot of ground until it until late 2024 Thanksgiving 2024 kind of bottomed on it it's run back up again now and it now sold off a little bit since sort of late 2025 what that relationship tells me is when the market is in one of these sort of large cap growth boons market capitalization weight which is just the index up performs everything else and then when that reverses everything else that is downstream of that.
equal weight, mid cap, small cap value, anything that's not large growth, market capitalization, weight starts out performing. And though I watch that as sort of what is the barometer of the, what is the market telling us? And to RSP has started out performing again versus market capitalization weight at around the same time that small cap started out performing at the around the same time that value started out performing. It's only very, very recent. There's a lot of volatility in that change. We've had the big reversal from March 31 for an in mid-May. That reversal has sort of gone back to trend now. And then the other thing that I always like to look at is OEF, which is the Russell, sorry, which is the S&P 100 versus the S&P 500. And so the 100 is the biggest 100 days in the market versus the 500, which is the biggest 500 days. It's sort of example, the 100 is in the role of the bigger caps. And it has the same, exactly the same chart as the equal weight versus the S&P 500 except in, in this relationship, it's reversed the 500 other smaller stock than the 100 other larger stocks. So in the dot com boom, the 100 up forms in 2020, the 100 up performs, 30, 20, 25, late 100 up performs. But the point of thing is that it hasn't bounced as much as RSP. So what that says to me is that the very largest stock are actually struggling a little bit and probably it's their valuations that are causing that to happen. So I think that we are in the very early stages of a reversal of what has been a large growth market for an extended period. So we've had a few attempts at it. I think from 20, 22 to 2024 of late, we saw a more normal market with small app forms large that reversed for a few years. I think we've now seen another reversal where we're back into a more normal market. We are getting a lot of volatility as it goes through. So the market hasn't really picked a direction yet, but it does seem to me that it's closer to the ceiling of the large cap growth versus everything else. If it goes back into a secular, small micro value markets, it can last a very long time because that large growth market has outperformed since about 2015 to date. So it's more than 10 years before that it was 2000 to 2015 was a value type market and then before that was the large growth market. So I think we're at, we have been in a large growth market. It is very stretched, looks to me like we are in the transitional period going to a value market, which could last for another extent, extended period time, 10 or 15 years. It takes a long time for that valuation differential to work itself off. At the moment, it's the bread between the most expensive and the most undervalued is in the 95th percentile, which means it's only been wider on 5% of occasions. On the metrics that I like, if you include quality in there as well, I think it's like 10 to 15 percentile, which means in practical terms, what that means is we're talking about the bottom of 2020. We're talking about the bottom of 2009. We're like literally talking about the last three months of the real drawdown. Because there has been this little bit under reported weakness in mid and small earnings, you've been able to see it in mid and small earnings from 22 until late 25. They were falling and they've now started bottoming and they are rising again through that whole period. Large growth earnings were very strong. I think that there's a lot of green shoots. I think we really are right now in the process of bottoming. I think it's like this whole Wall Street saw where they say, "Bottling is a process, it's not an event." But I actually think that's true. I don't think you see this one bottom. I think you see this enormous volatility around the change and that's what we're seeing. Do you have any thoughts on the AI cap? I think about a lot. I know you've studied past films as well. I just think about, I have both sides of this. I can get in my mind. Every boom is pretty much the same way. The people who are doing the building always lost to the end. It always trickle down. I can get all that, but I can also get this intelligence thing. The more you do the podcast and you have the tech guys on and stuff, you start thinking about what's different about this than some of these other things. The fact that there is this intelligence, and also when you see it, I'm sure you use it too. When you see it with your own eyes, what it can do, you're like, "Wow." I've got a full time group of people working with me now that are helping me and everything I'm doing. I'm just wondering if you have any context on that. I know you've studied history a lot. I agree with all that. I think that using it is eye-opening. I mean, it's so good. It's like having a good MBA, set a task. Does it almost immediately come back? Foulightly wrong. Has to be redirected a little bit. But you do that. You can iterate towards pretty good answer, pretty good work product. You know, whatever you're trying to make. It's incredibly fast. It's incredibly accurate. It's great. If you've got some big, complex document and you need it, summarise down it as something that's useful. It's incredibly powerful at doing that. You know, all of these things are one-of-one, I guess. So is it fair to compare it to the fiber optic build out in the 2000s or the rail line build out? You know, if anything, what they're spending the money on seems to depreciate a little bit faster than those other things they say. But I don't know how long a railway lasts for, but 25 years or more. The fiber optic cable is similar. It's like 25 years. And really what they upgrade is the boxes on the end. They don't really need to upgrade the glass in between. Well, you can upgrade the box and get better and better performance out. With these, the useful like, I think, 5 to 7 years, that might be generous. I have to turn over my computers faster than that. So I imagine that at the top end of town, they're doing the same thing. They're turning over those computers pretty quickly. It's entirely conceivable that all of this work goes into creating these incredible AI models and all of the value of a cruise to the consumer and not to the people who create these models because I have, I operate two or three models. I mean, I have, I have Chatchee, Patee and I have Claude. And I also use Gemini. Sometimes just throw laughs to see what it produces. But do you need like, do you need the very top level model or you're going to be happy with a model with one generation behind it for one tenth the price or like a commodity price? It's entirely possible that's what happened. The people, some people will need the very top end model and have to play for the top end model, but maybe the rest of us who are not doing that high level research, maybe we don't need that or maybe don't need it all the time, maybe we get better at passing them. You don't need to use the top end model to change the name of fire or something like that. It's hard to see how it all plays out. My instinct is that we all get to, you know, the gardener hype cycle. It's, it's real. You know, we all do get too excited about these things in the near term and then there's this drop of disillusionment where we didn't quite get there as fast as we thought we could. In the longer term we do and the same thing happened with the dot com boom dot com, internet companies have been completely true and informative all of this stuff that we use now and take for granted didn't exist 20, 60 years ago. There's still a huge crash in between. It did get there eventually. We've probably exceeded the promise of what we thought we could do in 2000, but we still had a crash in between because we got ahead of ourselves in 2000. I think the same thing's happening. The promise of these things is transformative. We're probably close to a singularity where the AI starts improving itself and it doesn't faster than a human can iterate and it just gets better and better by itself. But is it going to be one AI that dominates all of them or is it going to be multiple AI's that everybody gets access to everybody else's AI? They can copy it pretty quickly. They can figure out what they're doing. I think it's more likely to be that kind of world, which means that they get good return but not anywhere near the kind of super normal return they've been earning in the past. I think that some of that spend is a little bit discretionary. I think it's mostly because they're in a competitive race or leaving that it's winner takes all or there's a risk that it's winner takes all and certainly it's transformed. It's going to change a lot of these businesses. It's not going to be Google had search Microsoft had office. Apple saw consumer hardware or consumer goods, meta-sales, whatever it is advertising, Instagram and stuff like that. They've all kind of converged because there's lots of tools can do things that previously might have had a separate account for, a separate service for. I think that there's a huge amount of competition ultimately good for the consumer. I think the real question I think is, comes after the profits you were talking about. How much will this boost profits if any and then also where will that accrue and who? I don't know that any of us know that right now. We had Grant the Bond and he was basically saying things like this, effectively the people that use it first or get an advantage, they're going to boost their profit margins.
eventually it becomes a cost of doing business for everybody. And I don't know if that's going to be the case or not. It's just that. I don't know if the answer is to this, but I just think it's one of the most interesting things. Like, will this accrue down? Because this actually could be a good thing for value stocks over time. Like if they give advantage of this money that everybody felt spending and it accrues down into their profits, this could be something, it would be weird, but it could be the thing that ironically like reverses the thing in some cases. So I don't know the answer, it's just really interesting to think about. I agree. And I agree with all those texts, so it could easily be the thing that, you know, like when the only 2000s, you have a dot column. So therefore you get a, like you get a, you get a big boost to your valuation. Now it's just like everybody has a website. Like nobody thinks of that particularly impressive or not. It's just table stakes now. And the same thing's going to happen. I think for a, everybody's going to have an AI, I'm going to have multiple running stuff in the back end of their business as systematizing stuff. We've been doing it for a long time. We've been systematizing business for a very long time. Started with the industrial revolution. We're just getting better and better and faster and faster at it. I don't know that it's as transformative. I don't think this time is different. I think we're going to do exactly what we always do, which is, we're super impressed by when it arrives. We're pretty quickly. Head on at treadmill works. We just figure out how to use it. We move on to the next thing. Yeah, and personally, my whole approach has been like, we're going to do whatever all that stuff is. Like, I've got to use this as much as possible because I do feel like the people who will figure out how to use this. Like I just, I just upgraded to like the highest tier. Claude. And I've decided I'm going to like try to do everything I possibly can do. Like look at every single thing I do in my life and my job and everything and say like where can this add value and where can it not and just see maybe it'll push the limits of what I think you can do. So I figured just for like a month or two, I would try and just see what it can do. I think it's a great idea. I know lots of people are doing it. What do you have? You know, in terms of, if you've, I've been saying this repeatedly, but I think there's never been a better time to be an independent entrepreneur because you've got access to all of this super smart MBAs who can get stuff done. I always use the MBA as an example because I think that an MBA is somebody who doesn't have any experience in the realm of this smart and they do know a lot about what already exists. It's still need someone in there who has seen the errors that I think that the AI has got some of the nuance incorrect that make little errors all the time. So you still need to be in there making sure that they're making the right decision. But I think honestly, they'll get better and better at that. I think it makes the worst employees better. It makes highly productive employees like 10 times better, 100 times better. That way it's going to be a fun time. It kind of like reads the floor, I think. So like for you as a thinker, it gives you better things to consider. So like I agree with you, like the person still makes the better decision a lot of the time. But like it can just look at so much stuff at once that it sort of brings up like the information you have when you make that decision. And so I think that's the people who are going to the benefit here is like the AI is not going to get smarter than the people. I think if the people who really figure out how to use the AI, they're going to benefit is my guess. Yeah, couldn't agree more. What do you think about the other thing I'll stick it about in terms of is how this was funded? Because one of the unique things about this relative to sort of the 90s is at least initially this was very cash flow funded. You had some of the, you didn't have unprofitable companies. You had some of the best companies in the world that lots of cash fund to get now. We're kind of seeing a shift in a different direction. You're seeing much more debt on this and just so they can't spend. They don't have enough cash flow to spend to the degree they want to. Like do you think anything about that in terms of the changing nature of how it was funded? I think just to take a step back a little bit, one of the things that character right, we remember the dot com boom as a dot com boom. Like what really characterized it was, it was a large growth boom because there were lots of companies that weren't really dot coms or tech companies that got those very extended valuations. Like Walmart was one. G like maybe. G is sort of slightly unique case because it was Jack Welsh was the business guru and he was probably manipulating earnings and there might be too much. And massaging earnings would be the more polite way of saying it. But there are lots of these companies that were in no way shape or form tech comes. Even Microsoft was considered a little bit old economy at that time and they were. They participated. All of these companies just by virtue of the fact that they were big and growing got very, very high multiples. And I think we're in a similar sort of scenario now where it's not, no, Costco has got a ridiculous multiple. Walmart's got a ridiculous multiple anything that's large growth and has been able to pretty consistently grow through this period where there's a lot of cyclic, cyclicality, the cyclicals have suffered. The smaller companies have suffered. And so I think that it's, it's more a large growth market than it is really necessary to sort of drill down on how these max seven are financing themselves. So I don't know that that distinction is as important as I've seen many people discuss it. But I do agree that but we just said to be transitioning from a period where we have been, they have been cash flow financing. But like even Google's raising money now, that just seems bonkers to me. Google would be up there raising $80 billion, met us taking on debt. I think a lot of these things, a lot of these arrangements that these companies have are special purpose vehicles where they've got that the debt is carried off balance sheet. They're clearly spending more than they're earning free cash flow. It's right. I don't think that they're sort of obliged to spend like this. I think it is a little bit more discretionary because I think that a little bit like when Zach went into the metaverse and he was convinced that the metaverse was the future and they spent whatever it was, $12 billion or something extraordinary. And then he realized that he didn't, that market didn't like that and then nobody knew what the metaverse was. So they reverse course and went back to buying back stock. And now they've changed their mind again and they get to spend like that to get into the AI, arms race. I just, I kind of think that it's a little bit of a, it's a little bit misleading the way they're financing. It doesn't really matter how they're financing because they've got that choice. They don't have to do it. They could easily pull back and not spend just that the moment it seems like the market is demanding that. And I think of that. And I don't mean the, I mean, there's this pretty of demand for the compute. I think there's sort of maybe there's unlimited demand for compute. But it's more the stock market that's demanding it rather than, rather than consumers demanding. It's investors, and that's the signal that they're taking that investors demanding that they spend this, this sort of money. And if that demand went away, the stock market demand went away. Then I think the cap expense goes away too. It was interesting. Your point on like the non AI growth companies, when we talked about Robert Hanks, he was making this point. I think I used my thumbnail in that episode, 50 expert grocery store because he was referring to Walmart. It's interesting. Like the Walmart and Costco's like those might be the most difficult to explain valuations of all of them right now. I couldn't agree more, but then you know, Apple is out here at 10 times revenues. Everybody trots out that, I trot out that Scott McNeely. You know, when he was talking about some microsystems saying that 10 times revenues for some microsystems were ridiculous because he had to pay all the supplies and all that sort of stuff. And I just get, okay, Bermard, every time I put it out, which I think is kind of funny. Apple it 10 times like maybe everybody just says, what about margins? And then I know that margins are unusually high, but it's all very funny. It's usually like a defensive play. That's usually the market's going down. Walmart's like hanging in there going up, but you know, that's also when it's like a, you know, 10 times P multiple, not like 30 plus. Well, it's interesting. It's a strange time in the market. It's very straight. I think it's kind of interesting though. I think it's, I like, I think it's an interesting market as much as it sort of punishes value. I think it's a fun, interesting time to be in the market. Speaking of potentially over evaluation, I won't ask you to give me the acquires multiple analysis of SpaceX. I'm speaking about, I am interested to think about like, what do you think about these IPOs in general? I mean, this is just something like none of us have ever seen in our careers. I would have this three largest IPOs ever like back to back to back in the seed year. You're going to have a lot of supply coming on. Like, I can't even think through the implications of it, but I'm just wondering if you have any thoughts on it. I wonder if it sort of would mark the top. It sort of seems to be, there seem to be a little sell off when SpaceX came on, but then that reverse course really quickly. I think in the lead up to SpaceX, small value versus large growth, small value had outperformed by about 10% in a period of time. There was some weakness in large growth and some strength and small value. But then on the day after SpaceX launched, it was like a 3% rally in large growth and a 2% drop in small value for a 5% turnaround, which is half of the gain. It's clearly going to do something to the market where really that SpaceX is going to be a wild grart into the force fed into the goose, force fed into the S&P 500 index. It's going to have to buy a big chunk of it. Not as much as there's not a huge amount of free quite, even though the index is, even though the market capitalization is huge, there's not a huge amount of free quite. So it's not that gigantic with impact, but I'm sure that over time it will become more impactful. Then we have A-I-A-A-A-A-A-I-A-Fropic coming public at similar, like seeking $80 billion. It's a lot of money to suck out, but in the whole size of the stock market, it's pretty modest. I think at these events it probably, once you've captured all of your growth or you've captured the really rapid ramp of the S curve and you've got to
pretty good valuation, you're offloaded to the public stock markets if you're a private equity, if you're a VC, if the ducks quack and you feed the ducks. So that's what they're doing. I think when that happens, that sort of means that it's the entirety of people who aren't stock market people are aware of this thing coming in. When they start buying, you've lost all of your marginal buyers that are tensed to be the end of the cycle. I think that there's a time magazine cover about AI right now, which probably time magazine's got a pretty good track record of identifying whatever topic is most prominent in public's mind. So the death of equities as they famous 1979 cover and then the inflation being dead right before inflation took off another bit of high cover. Probably we look back in a few years and so this was the top. It's interesting because just to see one of the things I would criticize myself for is like I didn't realize like in this whole tech move, I didn't really realize like a lot of the value of these companies was in exceeding base rates for like extended periods of time. Like if you use base rates on a lot of these companies, it just didn't work out very well. And I probably underestimated the ability of technology to help with that. And like it was interesting. We said when we had Michael Bobiston on he was he did the paper recently, which you probably read on open AI, like and looked at them for a base rates perspective and said like this growth would be unprecedented in history if they were able to maintain it. And then like anthropic, I think like doubled the growth that he's looked at for open AI with the kid the paper. Like it's just for it's really interesting. I don't have an answer to it, but it's just challenging. But then you see something like SpaceX and you're like, all right, we've got a $2 trillion plus company now. I think it like 150 to 200 times sales. Like the the implied growth rate and 150 or 200 times sales is like insane. And then you think about doing that on two trillion base. It's like it's just crazy. I don't know what to think about. Yeah, the thing on my his paper, I think he was looking at like open AI's like it was either like their 20, 20, 20, 29, like some type of like three to five year projection on what they were expecting. But it's rapid is a is obliterated like that projection. Like what he had thought was actually done like obliterates the projection of. Yeah, but that's that that's a short term growth rate. Not necessarily like a longer term growth rate. But yeah, that's good point. I have also been trapped by the mobson base rate paper. Jake and I've talked about that a few times. We used that growth rate that base rate paper pretty extensively because that's you guys are quantity as well. You want to have some basis for your projections and that's a good that's a good basis. And then here are companies Google and Microsoft and and meta that they're just they break all of the old growth at scale. I mean, Amazon was another one. When Amazon went when we went through the pandemic, the growth rate on Amazon, I think it had like an 80% year at a hundred billion dollars something like that, which was just ridiculous. It's just unprecedented every time they do something like that they break all of those base rates. Typically you assume something it's large and mature is close to the end of its growth cycle. And you wouldn't put those put of numbers into into your DCF and here we are. They are producing those numbers pretty consistently. So yeah, it's worth it's clear that something different about these sort of businesses. I don't know. I still think that ultimately there's a transitional period where businesses can earn singular businesses can earn super economic returns. And after a while, all of these things that are new and unusual get assimilated by everybody else and the competitive advantage goes away. And they do have to return to earth at some point. I don't know when that happens, whether that's in the next 10 years or whether it takes a lot longer because they've got advantages that just can't be headed at all. I mean, I wouldn't want to compete with Amazon. I don't know how anybody ever competes with Amazon properly with their distribution. It just seems to me it's an impossibility to compete with them. We've reached that point where like, off it always used to say that a department store properly located was sort of this incredible business. And then along came Amazon, which sort of was was a better version of the department store, but I don't see how you can, how you can hit Amazon. That Amazon seemed to be the least loved of the sort of mag seven named at the moment. So I think that there's a lot of, I still think there's a lot of speculation in this market. A lot of the metrics that I track seem to show there's a lot of speculation. I don't really know that we in the middle of a stock market, in the middle of a spec, you would have stock market boom. It's hard to say what the real long term returns out to these businesses. I think that there's a lot of picks and shovels makers like the semi's are clearly have historically been cyclical. I can't say that they're not cyclical anymore, but they are right now at the top. The top of the topic of thought looks like they've tended to secular growers. I don't know the fiches. It's hard to predict. Would you get, you know, it's interesting, the word speculation, just because it's like, I think most people like buying the S&P 500 feel like they're buying the biggest, the best companies in America. And what a lot of people probably don't understand is that a lot of those companies are very expensive. And they kind of are, I mean, you know, who knows what the future holds, but it is a little bit speculative. Certainly. All those valuation metrics we were talking about the start show that collectively they're expensive, individually they're expensive too. They tend to be more expensive, the bigger they are, which is, which is, which is a little bit, that's not unusual, but then for that to generate more performance than cheaper stocks that is unusual. And so that's it. But that phenomenon, it's not unprecedented, it's unusual, it's happened six times and everyone's been around a big technological boom like dot com boom and then before then like the electronics boom. And then you go back and it's like the 1940s and then it's like a telegraph boom before then. They're all weird technology, but the technology has to railway boom. The technology has changed, but the human behavior reaction to it hasn't changed, where we get too excited about it in the short term, bit it up too high. The pigs and shovels, sellers do well as well. But ultimately it does sort of all get a simulated return to it. And I don't really know how it happens. I just know that it has happened in the past and probably will again in the future. Do you have thoughts on like valued investing in disruptive periods? I don't know if you read Kai who's latest paper, but it was really interesting. Because he he looked at value like during this period and he looked at disrupted industries versus non-disrupted industries and the non-disrupted industries values work just like the whole time. And it's continued to work and disrupted industries has struggled. So now obviously it's hard. He's using some advanced metrics to try to identify and advance what a disrupted industry in is like, but do you have any thoughts on like value investing during these disruptive periods? I think it values pretty consistent for the most part. You know, your return is determined by the multiple that you pay and the underlying growth rate and reinvestment rate and all of those sort of things. I think value is reasonably consistent. The only thing is that the multiples do very a little bit, particularly in burn times like now where we all become performance chases a little bit. We start following the things that have worked really well. And then that capital comes from somewhere else and the capital gets pulled away from what hasn't been working recently and that tends to be small value and so the multiples collapse there a little bit. But the underlying earnings are remarkably consistent across that group. There's some cyclicality. There's more cyclicality in small and micro. And so that's cyclicality plays that too. That's one of the things that I've been talking about a lot since 22 from 22 until sort of late last year. There was an earnings recession in the US for small and micro and mid cap companies. All of them saw that things fall or sort of trade sideways for two or three years. At the same time, the big end of town was doing very well. The earnings were going up in a straight line. They look like they're going a little bit parabolic. A lot of that is because they're investing and they're getting some return and what they're doing. But when you compare the two, it's sort of stark that you've got one group of his earnings going up and got a standard multiple as a result. And the other group has earnings going down and a shrinking multiple as a result. The outcome is it's wide bifurcation between the two portfolios and tell you would say, well, why would you ever do cyclical value when you get you can put more money to work? You can put it goes up more consistently. It makes sense to me as transformative, it's hard to then say, well, what next? And that's what I think the investor or what I try to do is more than being a value-going, more than sort of being systematic. I try to be a handicap. We're trying to find not the best horse, mispriced horse in the sense that if there's a little bit of recovery for small and micro, which I think we're already seeing, it's just taking a little while for it to filter. And I do think that the oil price running up the way it has hasn't held because an interest rates running up, I don't think that's helped. They tend to be, you know, but they're just more economically sensitive to small and micro guys. And so I think that all of that together has created a little bit of a perfect storm to sort of really smash small and micro and me. I think we're slowly now.
starting to see the transition when the multiples get as stretched as they have for Mag 7 and for the big end of term. On earnings that have been on all time high margins, it's hard to see what where else they can go, but they can keep on extending them multiple for a short period of time, but it's still a short term thing. If you believe in mean reversion, then the smart bet is small and micro value, mid cap value. If you think that we're in this single already, we're going to take all, then you'd be left behind. If you don't get on the train, you get six months to get on the train, or you'd be left behind forever, you'd be a second class citizen, while everybody else is on a moon base, and you need to get into the large grades. Personally, I think it's a mean revering market. Yeah, I hope so as well. It's interesting, like, on these broadening plays, type things like small outperforming, international outperforming, value outperforming. It was interesting how the war was just kind of a turning point in that. Those things were raging coming out at the beginning of the year, and then the war immediately reversed all that. So who knows? Maybe now that the war is at least somewhat resolved, no one knows what is in the deal. Maybe that will help on this front. The funniest thing is particularly energy, because I had a little energy concentration. Energy is like 3% of the stock market capitalization, has historically been 12%, probably not likely to go back 12%, we're at a less energy intensive economy than we used to be. But energy ran up before the all moves was blocked before the conflict. And then when the conflict came into public imagination, like oil did run up very rapidly, but the equity sort of topped out at point. And now that the straights open again and there's a piece of chords been signed, and oil was dropped off the mat, I think it would be, it's probably not impossible to imagine that this is the time when energy starts rallying again, because it makes an difference in doing exactly the opposite of what everybody expects. And that's about all the generally expecting the market, the path of maximum pain, as they say. Well, energy is interesting too, because of the AI play. It appears we're going to need a lot of energy. Regardless of how AI plays out, it appears like in the coming years, they're going to need a ton of energy. Do you think it comes from, I mean, I think that this some suggestion that comes from that for guests. But I mean, I think I've died actually knows some people who work for the sort of the mag seven and their energy teams. And I mean, it basically comes from anything. They're like, they're like our standard for what we will use for energy is like that. They're like, basically, if it is energy and it works, like they'll probably burn coal or something, whatever, if it works, they're buying their own power. They're buying their own power plants. Yeah, it's just, I mean, and who knows if that, I mean, we don't know what happens if they add in a long term, but like in the short term to your point earlier, like there's more demand for this than they can, they can meet. So in the short term, there's going to be a lot of use of energy, sir. Hopefully it's nuclear. I mean, I think it would be great to get nuclear going again. You know what? We're previously, I think that a lot of the issue will purely focused on on business. I think we're a little bit more broadly focused on maybe the risk of China as a competitor rather than as a, you know, not necessarily as a geopolitical power, but that too, but mostly as a business competitor. And they are certainly all in on AI. They're working very, very hard to make competitive. And they're, they're sort of right neck and neck with the states from what we can see. But when I was there a year ago, there was a suggestion that the top one in AI models were American, but the best value ones were China is. And so if we're going to stay competitive, we're clearly having a lot of an hour is going to be part of that incredibly energy hungry. They're more energy hungry than they have water hungry. So it's one of the strange things that we talk about water all the time, but it took about power. And it's going to have to be, you know, a power needs to going up dramatically, a power needs to going up in a parabolic fashion. So I think probably the only way we get there is, is nuclear. Although we are the study aerobia of gas, so there's a lot of gas here that we can, we can burn to. So maybe in the transitional period, we're being natural gas, but ultimately it's going to be a nuclear thing. Just an interesting aside for I let just take over is on that issue of nuclear because I totally agree with you like we should be doing way more nuclear, but the epsilon theory slash person, they had a really cool data point recently that like dramatically more people would not want to be next to a AI data center than a nuclear power plant right now. Like we want to not want to live next to an AI data center instead of a nuclear power plant, which seems irrational, but it kind of tells you a little bit about where the narrative is and I'll let you know. I think it's funny. I worked in a day. I worked in a telco, I worked as a you know, telco as a law as a general council before transitioning to investment in the finance. And they operated data centers and lots of data centers around. So I spend a lot of time in data centers that just an air-conditioned room with computers in it. So I'm going to be too worried about. I want to ask you about the way that you construct the portfolios for the ETFs, but I, before we get into that, do you remember, I think it's, it's, because I think when you explain it, it's pretty, it's pretty amazing. Do you remember that, Verdade? 55 times earnings stat that you and I talked about yesterday, what they, the point they were making with the semiconductor industry. No, I, and, okay, so yeah, so was their point was that, you know, I think overall semiconductors as a group were trading at 55 times earnings. And the, that implies, you know, 75% of the value is in the terminal value 10 years out. And, you know, the chances of anyone predicting what's going to happen in 10 years within any industry is like no one can do that. And then it also implies, you know, an annual growth growth rate of 16.5% for the next decade. So it just goes to show when you have something trading at multiples like that, what type of assumptions need to be, you know, and expectations need to be penciled in to get us there. Yes, semis have been cyclical. They've been deep value of lots of lots of times. I bought semis on occasion over the last decade. They've never had this kind of heat on them in terms of the upside multiple, but they've certainly had these sort of earnings reversals. They just, they have giant earnings runs when the demand comes and then they fall back to earth and they die 55 is 55 is a trough multiple. It's like, you know, they're like, they're like mines. You want to buy them when they're not earning or when they are over earning. Let's talk about the investment strategy specifically. So both both portfolios, both the ZIG and D, they're, you know, using sort of a value metric in the acquires multiple, but then you're kind of coupling that I think with a quality component. Do you want to explain sort of what you're doing there? The main difference between what systematic quantitative investors do and discretionary investors do is my focus is entirely on the financial statement. So just use what's in the financial statements to make the decisions. And I don't then interpret what the output of the financial statements is beyond that. The way that you value a company is to look at what it can earn on its assets, what it can reinvest of those earnings to grow and continue to earn on incremental capital and what it can pay out. And that payout can take the form of a dividend or a buyback. And you can take those components and come up with an idea for what the expected return is for any number of businesses. And naturally you need to use more than one year. You take, you can take five or ten years of financial statements, look at the variability of those returns on assets, returns on equity, look at the growth rate in those returns on assets rather than the returns themselves. You're looking at the improvement in the unbuying value. And out of that you can get an estimate for a base case, a bull case, a bear case over the next five years is the limit of predictability in my opinion that I had seen. I use Soy as a five year lookback period and a five year projection period. And you can come up with a valuation range for that. And then you look at the acquires multiple, which is what you're paying in the near term because it includes stuff in the balance sheet, debt, cash, minority interests, and so on, preferred stock, and similar things. And look at what you're getting out of that. And you can find the opportunities that are the best opportunities. You can find that the most certain opportunities and the most asymmetric opportunities and focus on those looking at the financial statements. Having done all of that work, you come up with a portfolio that looks like it's a range of businesses that are either cyclicals trading cheaply, pretty consistent businesses that they're not great, but they're available at a reasonably good price. Through the companies that are more franchise-like that do earn better returns on capital.
and do command a premium valuation as a result. And you would then value them appropriately so that you wouldn't need to pay, you wouldn't require as big a discount for the better companies, you require a bigger discount for the worst companies and try to create a portfolio that blends across that strategy, those different strategies. So there's different risk profiles. So the focus isn't on purely deep value cyclical, it is better companies trading at an unusual discount. So the example that I'll give currently, I've got booking holdings as one of the better companies that trades at a smaller discount. And on the other side, I've got some energy names that are clearly more cyclical trading at wider discounts. And then I have other things in between that trade, you're giving up some return for a little bit better quality, not knowing necessarily where the market is going to prefer more near-term returns. That's really the only thing, the only attempt, I'm trying to do that. And then I equal weight into those names because I think that they're all on this sort of optimal, not, I know it's making sound too sort of mathy or too precise because it's not. But we're just roughly trying to get the same level of risk and return and then sizing them all to about that same size. So they're all equal weight positions, different risk and return profiles on the, but out of the opportunity set, the best risk and return profiles, even though they have slightly different ones and there's slightly different types. But when you look at that portfolio, they're clearly much cheaper than many other stocks that are available. And they're not as high quality as many other stocks that are available because they're trying to find that little nexus between. Some of them are busted growth stories, Lululemon. I don't have any particular strong view on Lululemon. I see it's one that people criticize a lot because they say it appeals to value guys, but if you go and talk to anybody, it buys this stuff, they don't like it. And so that's the part of the model that I could be completely ignored. I'm ignoring the narrative and I'm buying it because it's cheap on a financial basis. I think the sales are still growing. It still looks like a pretty healthy balance sheet that still looks pretty healthy business. Could be completely wrong, but that's why we size it to a, it's 3% of the portfolio, it's wrong, and it's not going to hurt us that much. If it's right, then there's plenty of asymmetric upside in that position. I think that's really the main difficulty with value, particularly with deep value. You go buy things that everybody knows, our dog shit and be prepared to be embarrassed on about half of them, that the market was right. On the half that the market's wrong about, the hope is that the return, magnitude and frequency of return outstrips the magnitude and frequency of returns that don't work. And that's how I construct the portfolios. So over the long term, I think the returns are, in terms of what the underlying earnings growth and what the portfolios can return to reasonably consistent, returns get better when it gets cheaper because you get a bigger discount, better returns get lower when it gets more expensive. Value got very expensive in 2015, and it's spent the last 10 years working off that over valuation. They get overshot in 2020, and then it had a big catch up from 22 to 24. They might have got ahead of itself a little bit. But right now, in my small and micro portfolio, and in my big and large gap portfolio, they're both trading pretty close to the bottom end of the range, long term valuations, long term, and that's including a little quality adjustments. So I think that I'm pretty optimistic at this point for the forward returns in both of our strategies. And I don't know the answer to this, Jack, you may have an opinion on it too. Like I don't even know if it's possible within ETF, but would there ever be any, would you ever see an opportunity, and I guess what'd it even be possible if we had another major, in some point in future, we will have another major sell off, but something, I think back to 2020 when you had that, 30% down or whatever it was, no matter what, whatever, 30 to 40 days. And if you were able to rebalance sort of into that, or during that, you could really, especially a systematic strategy, and the one, because you're saying, there are names in there that are really deep, deep value, not all of them, but there's a portion of them, and that's where some of those explosive returns can come from. Can you even do that? I know with a separately managed account, you can rebalance whenever you want, 'cause that's just part of the, but within ETF, a lot of times there's these set rebalancing periods. - Yeah, so I'm on a, Zigg is active, so theoretically I could rebalance Zigg any time I want. - Okay. - Deep has tracked an index, but we're gonna transition it to active. We're doing that right now in the process of doing that. It hasn't happened yet, but that will, that will go through before the end of the year. I still try not to rebound on discretionary, on a discretionary basis, because there's some cost to rebalancing, it's sort of modest in an ETF, but there's still some cost. But I also think that I rebalance four times a year, you could rebalance on a monthly basis, and it doesn't improve returns much or at all. If you rebalance on an annual basis, you're on the risk that you have a March 2009 scenario, or if you rebalance state as September, you get half the returns, that you would have got if you rebalanced in March, it was close to the bottom of the GFC drawdown. They're putting it Corey Hofstein has talked about a lot, timing luck in rebalancing. I think you get closer and I'll put the quarterly rebalance, with a monthly rebalance, you slightly, you're a little bit closer to that curve, but you also have this phenomenon where, if names got a little bit of momentum, then you're always anti-momentum when you're rebalancing away from those names, and so quarter gets you a little bit of momentum in some of these things. I think that that anti-momentum versus momentum, rebalancing monthly to quarterly, it's not clear that it adds enough return for the cost of doing it. Or I think that a quarterly rebalance is enough. I have the discretion to rebalance more often, but I don't think that I would exercise it. - Right Toby, this has been great. We always appreciate your time, and love having you on to talk value investing, and all these other topics. But we also have to acknowledge that tomorrow, we have the US men versus Australia. So we will see how that game plays out. We're still friends today, at least, correct? - Well, I can't believe it's so, I'm very happy with the. - I'm hoping Australia takes the value portfolio, and US will take the growth portfolio for now, or maybe you watch, it's gonna be value's gonna clobber growth tomorrow, we'll see. - Yeah, it's a shame. My kids play soccer, I played soccer when I was a kid, I haven't really followed it that closely, but let's go to USA. - I like it. All right Toby, thank you very much. Have a good one man. - Thanks, Carlos. I always appreciate it, thank you. - Thank you for tuning into this episode. 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