a tricky thing about today is we worry that this may be an earnings bubble. 2000 was a little bit of that, but mostly evaluation bubble. We saw earnings bubbles in Europe, in 2007-2008, where the earnings had just got up 100% over four years. And even today, they are struggling to make it back up on an index basis to those levels. We are likely to be in a situation where over the next 12 months, we see more supply come into the US stock market than has been the case in living memory. Understanding why you're getting paid for the activity you're doing is really crucial. Just because something changes the world doesn't necessarily mean the profits accrue to the people who built it. Ben, welcome back to Excess Returns. Thank you for joining us. Very happy to be here. We were just talking about 2021 the last time you were on the podcast. It's hard to believe it was that many years ago, but we always appreciate having you or the other folks at GMO on with us and our audience. You spend your time managing portfolios and building investment strategies, but you and your team also think deeply, read extensively about markets, valuation, asset allocation, stock market history, and a number of other investing topics. Today, what we thought we would do with you, and we're excited to do this, is look at some of the recent research that you've put out, the firm has put out, and work through those items with you. I think we're going to start with the AI boom and possibly bubble that we're in, and talk about how that correlates to past market bubbles, and then we'll get into some of the research that you've done on private equity and some long-term return forecasting expectations. Looking forward to a good, thoughtful discussion with you today. Where I want to start with you is related to a recent piece of research that you put out. It was looking at where we are today in the market with AI and looking at it from an investment bubble perspective, where valuations are, the markets, the speculation that's underneath. One of the things that you said is that it's one of the easy bubbles, easy ones as you put it for an agnostic investor to handle. So, can you just explain what would be the difference between an easy bubble and a hard one to understand and what you meant by that? Yeah, so for us, an investment bubble is a situation where at least some important asset out there has risen to a level where it feels pretty close to unownable. That's not the only definition of bubble, but from the standpoint of putting together a portfolio, that's a useful one. And we've had a number of those in the last 25, 26 years. And what makes some of them different from others is if you believe the situation that we believed at the time, so we believed we were in a bubble in each of those times, how hard is it to put together a portfolio that can avoid the worst of the pain, then yet allow you to retain your clients? Because the problem with some bubbles is that avoiding them means running a portfolio where if the world was normal, that portfolio would make no sense. An easy bubble is one where you can take a normal amount of risk and still avoid most of the pain of the bubble. So my example of an easy bubble in the last quarter century was the internet bubble. In the internet bubble, gross stocks around the world were horrendously overvalued. The S&P 500 was the most expensive it had ever been in history. And even today, it has still never passed those valuation points, at least on most normal valuation metrics. But it wasn't that hard a bubble to navigate, because you could actually own a normal amount of stocks. If kind of normal is a 60/40 portfolio, you could run a portfolio that was 60% in stocks, and yet not have to own any of the really overvalued stocks. You just had to say, okay, instead of owning large cap growth, I'm going to own small caps, I'm going to own reats, I'm going to own emerging equity, I'm going to own emerging debt, you're still owning risk assets. And the crucial thing about the fact that you're still owning risk assets is let's imagine for a second that you were wrong, and the world was completely normal. Right. You still own a portfolio that has a normal amount of risk assets, you still own a portfolio where if everything is normal and you'll get a normal return, there'll still be plenty of tracking error versus the app weighted portfolio. But you are not necessarily giving up long-term returns for the sake of saving you from the pain. So that was a bubble that was relatively easy to navigate. The next bubble in the global financial crisis was a lot harder, because it didn't just affect large cap growth stocks. It affected all risk assets everywhere around the world, as near as we can, we could tell at the time every single risk asset was substantially overpriced. And that meant in order to save yourself from the pain, you really needed to not own risk assets. That is an incredibly hard thing to do, because if you're wrong, you are giving up a tremendous amount of return for your clients. And if you are not raw, if you were not right quickly, your clients are going to really lose patience off with you. The next bubble, which from our perspective occurred at the end of 2021, was an even harder one to deal with, because stocks and bonds were simultaneously really overvalued. That was a time where everything with duration was really overvalued. So avoiding losing money didn't just mean moving to high-quality bonds from stocks, but it meant moving to cash or something cash-like. And the problem with that is everybody knew cash was going to lose to inflation. And the other thing is, if you've got clients, you guys have clients, we have clients, the one thing they don't want you to own for them is cash. You do not need a professional money manager to own cash. You can do that in the bank. So moving your clients to cash, you have the shornest potential leash there in terms of time. So that's a really difficult bubble to deal with. The AI bubble, we think that this is really a bubble in US stocks writ large. So large caps, yes, but small caps in the US still look pretty overvalued. The good news is, if you move outside of the US, you can still own plenty of risk assets, which are priced to deliver a decent return. So this is one of those times where you can put together a portfolio of stocks and bonds that avoids most of a peril from the bubble we think exists today. And yet, isn't an insane portfolio to own if you're wrong and everything is actually norm. And we'll put these risk and return charts in here. So people can see them because you have all these different asset classes, both in 2000, 2007, I think, and then you have it as of late 2025. What does the just talk, I mean, maybe you could just explain what we're looking at. It's kind of obvious based on what's the chart, but I think it would be good to binge and just walk through that real quick. And then talk about the difference between, I guess, what does this, does the slope tell us anything? How the slope is positive on two of them and then negative and in no seven, can you just talk to that? Maybe that's to your evaluation point, but I'll let you explain. Yeah. So the the charts you're talking about are charts, we have built of the forecast. We were showing to clients at the top. So this is not some sort of data mind backcast, but the forecast we were showing our clients at each of those times. We're showing them as a risk reward scatterplum. So the horizontal axis, as you go out farther from the origin, you're getting to riskier and riskier assets, vertical, the higher you are on the page, the higher the expected return. And the importance of that risk reward line of that regression line is that's basically telling you how much are you getting paid for taking risk. The slope of that line should be positive, right? In a rational, properly functioning capital market, you should get paid for taking more risk. Now risk isn't exactly the same thing as volatility, but it's close enough for this purpose that you should really see a positive slope to that line. Under normal circumstances, if everything was priced fairly
we think that that line would have a slope of about 0.7. So if you look at that line in 2000 and say that line that has a slope of 0.4, that's still positive. It still means you are getting paid for taking risk somewhat less than normal, but not an utter disaster scenario. And so when we look at a risk reward line like that, we say, okay, well, you probably don't want to own more risk assets than normal and it's time like that. Maybe you want to shade a little bit less, but this is not a time where de-risking your portfolio is a crucial thing because you are getting paid for taking risks. If we looked at the world in 2007, that had been completely a turn on its head. You were paying for the privilege of taking risk. This was the first truly global bubble as Jeremy Grant was saying at the time, every single risk asset we could find looked massively overvalued versus history and not that mispriced relative to each other. So one other crucial thing that was going on in 2000 was the average risk asset looked much better than the half-weighted stock market. So if you were prepared to own a risk asset portfolio that looked different from the market, you could make a lot more money that way. In 2007, you couldn't that equal weighted portfolio of risk assets looked almost exactly the same as the half-weighted portfolio. So you couldn't diversify your way out of the pain. You needed to move up that line. You needed to move towards the origin. Now in one sense, like an optimizer would say, well, that's easy. All of the low risk assets have higher expected returns and lower volatility. Man, this is a piece of cake. I can just put together a portfolio of just bonds and cash and I'm fine. But as you guys will know, justifying that to your clients is really hard. Just applying it to your optimizer is easy. But justifying it to your clients is really hard. In 2021, we didn't have a situation white like that. You were not paying for the privilege of taking risk. The slope of the risk were more like was positive. But everything was really below zero. So the across the length and breadth of assets just about everything had a negative expected return in real terms. And that to us, seeing, well, that's not a sustainable situation. There really needs to be a positive real return to investing over time. And so what you want is to own assets where a reprising is going to be as painless as possible. And that means you need to own stuff with really short duration, right? A reprising of stocks is devastating if it's a reprising downward because stocks have a really long duration to them. Bonds have a long duration. Real estate has a long duration. Infrastructure hit a long duration. Everything that has private in front of it, well, maybe not private credit, but other things have a long duration. So what you needed to do was avoid duration again, an incredibly difficult thing to do. As of this fall, we thought US equities looked really overvalued. The rest of the world looked just fine. It was easy to put together a portfolio that took a normal amount of risk and looked pretty good. The bad news since that is that a portfolio like that has really done quite well, right? The NAHAN US risk assets have done well. And their pricing is somewhat less attractive than it was then. The slope of that risk reward line was 0.4. Then it's 0.1 now. Now it's still about 0.4 if you excluded US equities. And for our part, we kind of want to at least in the portfolios we're allowed to. So in that world, yeah, you are getting paid for taking risk, but it is getting to be a tougher environment. And again, it got there the good way by having emerging do well, having non-US stock equities do well, having emerging debt do well, having almost all risk assets do pretty well. It's interesting. You think about what's obvious to the optimizer, what's obvious to the person is like the opposite of each other. Effectively, and I guess like client behavior and expectations is the sort of the gap between those two things like even if it's obvious for an optimizer to own like the risk-free asset or something, you can't actually do that in the real world. Yeah, it's very difficult to do that in the real world. And one of the things the optimizer doesn't know that your client cares a lot about is there is some risk you are wrong. And there's a risk it'll keep going too. Even if you're right in the long run, there's a risk it's going to go on for a number of years. Yeah, I mean, that's pain. It's you really believe you're going to be right in the end. You can put up with that pain, but it is so difficult for the client to have that faith. Look, I can tell you as someone who has lived through these bubbles and believed this stuff going in, as the market is moving against you, it is hard to maintain that confidence yourself. And if this is merely a professional that you hired because I don't know, you liked the story they told and you liked some of their historical track record, your level of faith is going to be a lot lower than my level of faith in myself is. So the real problem with these situations is if you need to run a portfolio that is going to look very stupid if the world fails to fall apart quickly, your client is going to fire you. That is bad for you. It is also bad for your client because your client is overwhelmingly likely to fire you and hire the person who was doing the exact opposite of you. And so we saw this in the internet bubble. Clients would fire us and hire the aggressive growth managers. And so they made less money on the way up and they lost more on the way down. Have you learned anything about how to manage that? I mean Jeremy told some great stories, but he was on recently about this, you know, the late 90s in Clients firing you guys and things like that. Like, have you learned anything about how to maybe make clients like stick with the strategy better? I mean, part of this is human nature that you probably can't adjust. But I mean, if you learned anything this time relative to what you went through that time. So we've learned a few things. I think I hoped. One of them is about in managing the portfolio. And so in the 2000 event, we were running more de-risked portfolios than we needed to. And it worked out just fine because bonds did well. And you know, the path for stocks was a little bit bumpy, even those stocks that went up. But in retrospect, we didn't need to be as underweight stocks as we were. And that is certainly something we are keeping in mind today. We are trying to make sure we don't own any assets that we don't think are giving a decent risk reward ratio. But we are trying to hold on to those risk assets we think we can afford to hold. Because what have we learned living through four bubbles in 26 years is man timing this stuff is tough. And they can go on longer than you ever thought possible. And having a portfolio that only makes sense if the bubble burst quickly, it's a tough way to make go living. So we've tried to do some stuff in terms of making Bayesian adjustments to our forecasts and trying to build portfolios that are robust to that. Another thing we're doing is being very open about what we're doing, why we're doing it. And you know, what what the likely consequences are to the portfolios. But man, if there was a way to do this without the career risk, without the client firing you risk, this would be a much easier business. How would you contrast like the 2000 period to today in terms of one of the questions a lot of people have like I mean, many people will agree like the AI type stocks are in a bubble like environment, but some will argue now like the more large cap stocks that represent most of the index are at least that maybe expensive, but at least at like non bubble like valuations and they'll contrast that with 2000 will say those those types of stocks were at bubble like valuations. I mean, do you think that's fair? Yeah, it is certainly in the case if you look at, you know, the the the giant stocks, most of them are not creating, treating it crazy valuations. So let's hold SpaceX aside, let's hold Tesla aside, let's hold Palantir aside, but you know, if you look at Microsoft, hey, Microsoft is trading at much lower valuations than it was six or nine months ago. And the valuations don't
seem crazy relative to earnings. We saw earnings bubbles in Europe in 2007-2008, where the earnings had just got up 100% over four years. Even today, they are struggling to make it back up on an index basis to those levels. We saw the same thing in EM in kind of 2012. Earnings bubbles can exist. One of the things that can drive them is rapid increases in investment. Because the thing about investment in the long run, what matters with investment is what is the return on investment of that. What's the ROIC? In the near term, if you think about investment, it's done after the income statement is over. I am Microsoft. I'm spending $200 billion on data centers. None of that comes out of my income, but all of that spending winds up somebody else's revenue. Eventually, I'm going to have to depreciate it, but I depreciate it over time. As investment is going up, that kind of mechanically makes earnings higher than they would otherwise be. Actually, right now, we're in one of these situations where if it takes three years to build the data center until that data center is complete, there is no depreciation. Right now, given how rapidly the investment has ramped up, a ton of that investment is not just only depreciating one six to one seventh of the spending, but hasn't started depreciating yet at all. So this is a very good time for corporate profits. We think probably an unsustainably good time for corporate profits, but relative to 2000, a smaller portion of the market is trading at insane valuations. Yeah, that earnings bubble thing is so important because people don't think people always think about price bubbles, but they never ever think about earnings bubbles. And if you do get into a situation where earnings are just unsustainably high, then you can seem to have reasonable valuations, but still be in a bubble, which I think is tough for people to understand. Yeah, I mean, I'd say people are, I mean, not that anybody cares about this anymore, but let's say you're looking at resource companies. Everybody knows you doled by resource companies when their PEs are really low. Their PEs are really low because you are in kind of a peak earnings situation. And the capital cycle is about to come around and bite you on the ends. You buy resource companies when the PEs is high because the earnings have collapsed. We are in the midst of an amazingly large capital cycle associated with AI. And I think we're going to be in a situation where before the end, right, the SK Heinix's and microns of this world will look really cheap on a trailing PE basis, but turn out to be lousy investments. Yeah, I was thinking about the semi-usage exactly what I was thinking about when you said that because 10 semi-usage have traditionally been cyclical businesses, but the argument now, which is probably a bubble like argument is they're not anymore. You know, we have this new thing, AI driving everything, and this is no longer a cyclical business. Yeah, and then of course it has to be a cyclical business. I mean, one of the things about the memory makers is it's not exactly a commodity, but we've had all of the characteristics of a commodity business. And so the commodity cycle and the capital cycle tends to be really painful. You can get situations where that cycle turns into a super cycle, right? We had this iron ore super cycle. When from 2005 to 2012, companies were investing to be able to deliver more iron ore, but it still kept working out because China's growth in demand was just higher than anybody ever expected. Eventually, those companies got smashed, but it took a lot longer than anybody expected. What we don't know right now is how long it is going to take for supply to keep up to catch up to demand. If it doesn't, then why? This will be like this weird failure of capitalism that we've never seen before. Good happen, but that would truly be a this time as different situation. I want to ask you about AI CapEx in general, because I know you guys have studied history a lot, and all of us are trying to figure out what to make of this whole thing with this amount of spending. I'm just wondering in a historical context, like how do you think about this? I mean, if you look at capital cycles in the past, I mean, this doesn't necessarily bow well for the people that are doing the building of this in terms of how it's going to work out, but then people argue, you know, this is intelligence, this is different, this is something that's going to replace human intelligence. So we can't really analyze it in that way. Like how do you think about that? Yeah, so I mean, for the for one thing, in terms of scale, right, this is a big CapEx cycle, but it is certainly not an unprecedented one. I think if you look at the data center spending this year, it's kind of forecast to be, I don't know, 700 billion, I think is the most recent number I saw. And that's like 2.2% of US GDP. So it's a big number, a little bit bigger than the fiber optic spend in the late 1990s, about half this size relative to GDP as the railroad spend was and cut the middle and second half of the 1800s. It's probably pretty similar to the electricity build out kind of near the turn of the century. So it's big. And there aren't a lot of things that have been that big. But there have been things that relative to the economy have been of reasonably equivalent size. Historically, they haven't worked out well. And that's for a couple of reasons. One is if you've got a transformational technology, it is actually not hard for people to understand, man, this is going to change the world. And you know, whether it was canals or real roads or electrification or the internet or automobiles, people were right. It really did change the world. The tricky thing is just because something changes the world doesn't necessarily mean the profits accrue to the people who built it, right? Railroads changed the world. Railroads didn't change the world because being a railroad was awesome. They changed the world because they completely collapsed the cost of long distance transportation, which meant you could have much more specialization in manufacturing. You could have much more specialization in agriculture. And you could move people across the country, right? California couldn't really have existed before the railroads. But running a railroad has never been an amazing ROI activity. And when you get a ton of investment, that tends to depress the ROI in that area to begin with, right? The UK did this before the US and the UK, you know, the first company that built a railway line between London and Manchester, if it had stopped there, they would have made a lot of money. Unfortunately, they were followed by five other companies. And once you have six railway lines going from London to Manchester with huge over capacity, it's not just that the marginal dollar invested is going to have a lousy return, you will destroy the return of all of that cat ducks. So what has almost always happened when you have a situation where you've got this transformational technology and really good early ROI is you get way too much investment and you destroy that ROI. It doesn't mean that the technology doesn't change the world, the world railroads did electricity did. The internet did that fiber investment was a lousy ROI, but it did enable the world we live in today. The tricky problem is, unless you are stopped from doing it, the natural response by capitalists is to throw enough money at the opportunity that you are going to destroy the return on the desk. Yeah, when you were saying that I was thinking about how this has been funded and one of the differences here between fiber and what's going on now is at least at the beginning, this was funded through cash flow as opposed to debt. But now you're seeing that debt get added on. And so I'm wondering if that plays into your idea of like, they're just going to keep throwing money ahead, it, even if it might have been initially funded by cash flow, they're still going to pile the dead on and they're still going to keep throwing money at it to the point that it doesn't make sense. Yeah, I mean, I think that is going to happen.
unless it stopped by something. Right, if we are fundamentally incapable of providing enough electricity to these things, and so as much as people would want to build an infinite number of data centers there stop, well, maybe they can kind of be saved from themselves. But otherwise, capital will flop. And, you know, one of the things, my former colleague Ed Chancellor, who's kind of one of a premier economic historians of bubbles, points out exists in bubbles is the financing gets to be really sketchy. You get Ponzi finance, you get circular finance. And my God, this cycle, we have seen some incredible deals from the standpoint of strange ways to finance purchases. What they have in common is they are structured in a way to look as profitable as possible initially. So open AI makes a deal to buy tens of billions of dollars worth of AMD GPUs. Now, if you look at the way that deal is structured, open AI is being given warrants on an AMD stock, which is worse, half of them. So effectively, they are buying these GPUs, half from shares of AMD that they are being granted. AMD could have given them a 50% discount. Instead, right, that would have been a more straightforward way to do the deal. But this one's going to make AMD look a lot more profitable. And still deal with the fact that open AI simply did not have the money to pay full price for all of these chips, even if they had wanted to, you know, the recent deal with in profit, offering to least $36 billion worth of, of alphabet, TPUs, where Broadcom is stepping in and promising to buy back the TPUs in the event that in profit defaults in order to give this an investment grade rating. Well, it's structured in a way that this does not show up entirely as a liability on Broadcom's balance sheet, because it's viewed as low probability, but it does benefit from Broadcom's credit rating. And you can be sure that in this deal, Broadcom is being paid for the fact that they are making the deal possible. It is, it's interesting as for the average investor, it is very hard to have any idea what's going on with any of this stuff. Like the circular nature of the circular deal with this company, this company and that this company's over to this company. It's like, unless you're in the weeds of this stuff, this is very, very hard to figure out what's going on. Yeah. And some of it really relies on the fact that the accounting isn't going to keep up. And, you know, we saw circular financing in the internet bubble, but a lot of that was, I don't know, tamer. Right. It was two dot com firms putting ads on each other's sites and declaring that as revenue. Um, this actually involves lots, lots more money. Um, and creates more risk of problems when things go wrong. One of the nice things about the internet bubble is the internet part was funded basically entirely through equity. Um, so there were no systemic problems when it went wrong. Right. The housing bubble was funded through debt. And there's lots of systemic problems when debt goes back. Uh, this time around, it's a combination. Plenty of it used to be funded with equity, but increasing amounts are being funded with debt. I think the hyperscalers have doubled their, uh, debt ratios in the last nine months. I mean, they are taking out huge amounts of debt. They're still very high quality companies. And I'm not, I'm not saying they're going to default on this debt, but they're taking on debt really rapid. Just one more quick question. This before we go to your return forecast, the, the idea of all this issuance coming out now, um, you know, you've got these big IPOs, you've got companies that we're buying back shares and now issuing shares. How do you put that in context in terms of like how you think about that and what it means for the market? Yeah. I think that's a really big deal. Uh, and, and one that I hadn't understood how important it was, um, until I started to a couple of years ago, there was this, um, good paper. I can't remember who wrote it anymore, but, um, the inelastic markets hypothesis that showed that, you know, the way traditional finance treats, um, the financial markets is that they really should be very elastic. That if a little bit of demand comes in or a little bit of supply comes in that should have a very small impact on prices. Um, and what this paper purported to show was, no, actually supply and demand really matter a lot. Um, and so one of my colleagues, John P's presented that paper internally and then tried to replicate, uh, their findings and found, yeah, it's really true. Um, the supply and demand matters a lot. There are natural experiments you can look at where the supply or demand are there, but we know there is no information flow associated with them. And it still has an impact on prices. And right now we are likely to be in a situation where over the next 12 months, we see more supply come into the US stock market than has been the case in living memory. Um, if we just get SpaceX and open AI and entropic and maybe a, a few other of the companies in, in dollar terms, don't matter that much. We could be talking about five or six percent of aggregate US market cap coming in as supply. Now the thing is it doesn't come in instantly, right? SpaceX went public a little while ago now. Um, but they only sold 75 billion dollars worth of shares. And they sold that at a $1.8 trillion market cap. So there wasn't very much additional supply that came online as more of the holders become freed up from their lockups. A lot more will be able to change hands and a lot more effective supply comes in. So if you look at the impact on the stock market, it's not when an IPO occurs. It's kind of in the 12 months afterwards because it takes a while. Um, for those lockups to expire and the stock to change hands, but kind of the rule of thumb, if you looked at history, is that a 1% increase in supply is associated with a 7 and a half percent worse return over the over the subsequent year. And if that held up in a linear fashion and we're talking about five or six percent, well, that would be a pretty ugly return. Um, I don't know that it's going to be that extreme at that level. It is hard to disentangle from the fact that the two highest points of supply that we've seen in the US market in the last 50 years were 2000 and 2021. And both of those were also times when the markets were kind of crazy frothing. So pulling apart how much of this was driven by the supply and how much of this was driven by, you know, bubbles burst. I'm not sure. But right now we're getting behavior that looks very bubbly. We are seeing a lot of supply or we are going to see a lot of supply. Um, and that may be a real challenge to the market. It's interesting like that in elastic kind of markets. I thought this paper, it's come up on the podcast before, but it came up with Mike Green talking about the flows from 401 K's, like into the market and the impacts that some of that can have the maybe is a lot more than people expect. Yeah. I mean, it's, it is something you really have to as an investor continually keep in mind. Like where is the supply coming from? Where is the demand coming from? How price sensitive is that demand? One of the things, you know, when the money is flowing in from 401 K's and let's say they're buying the S and P 500. Well, the S and P 500 is trying to buy the same percentage of Nvidia as it does GM. But if the holders of Nvidia are less price sensitive than the holders of GM, it's still going to have a bigger impact on Nvidia. And when you think about growth stocks, the holders of growth stocks are for perfectly reasonable reasons, less price sensitive than the holders of value stocks. So even if even if net supply is coming into the market and, you know, a completely passive fashion with no views associated with it, it will have different impacts on different kinds of stocks.
I want to shift here asset class return forecast here. But before we all put the chart up right now, but before we get into the actual forecast, I want to maybe have you talk about how you do this. So these returns that we're seeing in front of us right now, what is the process that goes into calculating these? >> Yeah, let me talk about the basic idea first. And part, all we're really seeing is that things will eventually trade at fair value. We use a seven year forecast because historically, seven years has been decent estimate of how long that takes on average, even though things can be much faster or shorter than that. So the way we calculate the forecast, the way we build it is by looking at the income, it's reasonable to expect from an asset, the growth, you can expect from that asset. And then adding an additional term for the gain or loss associated with the valuation shift that is required for that asset to come back to fair value. And we kind of assume it's going to come back one seventh of the way each year. Now there's plenty that can go wrong with that as in any kind of forecasting. But one of the things I like about it is it sort of is assuming that capitalism is going to work in the long run. It would be weird if we lived in a world where the return on capital in the cost of capital did not come into a line with each one. That's what capitalism is supposed to do. And if capitalism is going to do that, you're going to get this kind of gradual main reversion and valuations. You chose to break out low industry environment from a normal industry environment. And this why did you do that? So I said, we think things revert to fair value. What I glossed over was, okay, well, what is fair value? And the reality is it is much easier to come up with a fair value for assets relative to each other than in some absolute sense. So and again, even just take a step further back. Fair value to us is a valuation level from which you can get a fair return to that asset without having to have valuation shift. And so what's a fair return? What's a fair return to stocks? I don't know. Tell me what the alternatives to stocks give. The way we tend to think about it is let's start from cash. Let's start from kind of the ultimate risk preasset and say, well, how much more should I get paid for owning this asset because of its greater risk? So bonds are somewhat more risky than cash. They should probably give a return associated with that. We assume you're going to get somewhere around the hundred basis points of term premium for owning a bond instead of cash. Now stocks are a lot riskier than that. And in particular, they tend to lose you money at really unpleasant times. They tend to lose you money when the economy is going badly. And your income from other sources is likely to be lousy. So you should get paid a good deal more for owning stocks than bonds. Weat cuff that is around four and a half percent for stocks relative to cash. So maybe three and a half percent relative to high quality bonds. The thing none of that can tell you is what should the return on holding cash be? And as near as we can tell, there is not easy conceptual answer to the platonically correct return on cash. So what we do is we come up with a couple of different scenarios in which all of the asset classes are priced reasonably one to another. But where we can say, you know what, either of these scenarios could make sense as a long term equilibrium for the interest rate environment. Today our best guess is that we are in that low interest rate environment. So the return to cash in the long run will be somewhere around zero in real terms, maybe a little bit positive, but around zero in real terms. So after inflation, stocks need to deliver four and a half points better than that. In order to do that, they need to be trading at a normalized be he somewhere around 21 times. If we are in a world where cash is going to return more than that, and it used to return more than that, then stocks need to return more than four and a half. And if there if we push everything up by one to one and a half percent in terms of required return, well, then equity scant trade at 21 times normalized earnings. They need to trade at 16 times normalize to X. So that's why the interest rate environment matters. It changes the fair value for everything. And man, life would be convenient if I knew which of those scenarios we were in, but I don't. So we publish both of them. So the clients understand some of what can drive, you know, different returns from assets in the long run. What is interesting about the chart is clearly it shows that, you know, international over US. And so I think some of the highest conviction sort of ideas here, or where the most the possible best returns are sort of coming from this this value and deep value coher of the equity market. Yeah. So today we see a big gap between the US and the rest of the world. Now, it hasn't always been the case that the rest of the world had looked more attractive than the US. It got there the hard way by underperforming for a long period of time. But US stocks have outperformed over the last whatever 10 to 15 years. Some of that has been truly deserved because of better fundamental growth. But it's also been associated with rising relative valuations. This idea that the US should trade at evaluation premium to the rest of the world. It didn't exist 15 years ago. There was no history of the US trading at a premium to the rest of the world as of 2010. Today, everybody assumes it is the way the world should be. The other thing that has happened that has been important is arise in the value of the dollar. As of 2012, the dollar was really undervalued. Today, it looks substantially overvalued. So when we're building our portfolios, we want to take into account the fact that non-US equities trade significantly cheaper than the US. That's going to be a help owning non-US dollar currencies for US based investors is going to be a tailwind because of the overvaluation of the dollar. And then within that, from a style perspective, today, small looks cheaper than large pretty much everywhere. And value looks somewhere between quite cheap and extraordinarily cheap, depending on the market you're looking at around the world. A lot of times with these expected return projections, it's hard because you see something like the large cap growth and how low or negative those returns are. But it's not like the annualized return is likely to be in that range year over year. A lot of times, you can be in this environment, and then you get a bear market or big drawdown. And then that's how those returns actually come to fruition. Do you see what I'm saying? Yeah, certainly we are not expecting the market is going to go in a straight line from here to fair value over seven years. The way these things have tended to play out is yes, you will have a really bad year, right? 2022, the stock market went down 17%. That's seen though, that's really bad. But inflation was also really hot. So in real terms, it fell by a lot more and that made it a lot cheaper. It didn't make it cheap in the case of the US and some of the other markets had really did. But yes, a sharp bear market changes things quite quickly. And if that bear market happens to occur at the same time that we are experiencing fire than normal inflation, you can have a profound change in valuations pretty quickly. What's the idea of the concept behind the benchmark free portfolio? I'm guessing it's like you don't have to necessarily have a benchmark like the S&P. You can maybe have your own benchmark. But I'll let you kind of explain what you're trying to get out of that. Yeah, so there's people tend to put together their portfolios for a couple of different reasons, which are not fully compatible with each other. The 1640 portfolio kind of took form as some sort of happy medium because it was a nice blend of risk and return. It was a level of risk that in general people could live with. And because stocks and bonds under a lot of circumstances can be natural compliments. It was a real
reasonably sweet spot in the in the risk reward trade off. And so when we were building portfolios for our clients back in the late 90s, 60 40 was kind of a traditional way they would want us to build multi asset portfolios, but they would give us a bench one in the, the strange problem we were faced with in 1999 was we were running these portfolios for a bunch of clients. All of them were unhappy with us because we were underperforming and your clients will always be unhappy with you when you were underperforming. But we got two very different complaints from the clients. One set of clients was saying, okay, I'm looking at your portfolio. I'm looking at my benchmark. My benchmark is 50% S&P. You own 25 points in US large gap stocks. So I understand the fact that you don't like the US stock market, but that single bet is overwhelming everything else. How can it possibly make sense for you to spend that much of your risk budget on this one bet? That's stupid. We had another set of clients in the same portfolio that was looking at the portfolio and saying, wait a minute, you've got a negative expected return for the next 10 years for US large cap stocks. Why are you wasting 25% of my portfolio in an asset that is risky and has a negative real return? And so we realized we were running one portfolio, but our clients were thinking about it two different ways. For the clients who were really concerned with tracking error, we were taking way too much tracking error on a single bet. For the clients who were really saying, okay, 60, 40 kind of make sense from a risk framework. But what I really care about is absolute risk and absolute return. We weren't wasting a piece of their portfolio. Right. Why do we own 25 points in US large caps? It was out of fear that they might do well despite the fact that we hated them. So that was a piece of the portfolio that was not doing any good from an absolute risk and absolute return perspective from a tracking error perspective. It was. But if you cared about absolute risk and absolute return, you could put together a much better portfolio. And so what we started showing to the to the port to the clients in the fall of 1999 was, Hey, this is what your portfolio would look like if we didn't have a bench. And it was the fall of 1999. And nobody was really interested, even the people who hadn't fired us yet. We're not saying, yeah, what we want to do is get even more of what you guys are doing. But 2009 turned into 2000 and 2000 turned into 2001 and by 2001, you know, the first couple of clients started saying, Hey, you know, this bench work freeze. That makes some sense. So we launched the strategy in 2001. It's designed to take similar risk to a 6040 portfolio. But what we promise is we're not going to waste any of the portfolio in assets that the reason why they're there is fear they might go up despite the fact that we don't like everything in that portfolio has to make sense on its own without worrying about tracking error. And so it's a portfolio that isn't going to take an insane amount of absolute risk, but it feels no obligation to look like a traditional 6040 portfolio. We feel no obligation to own US stocks if they're not attractively priced. We feel no obligation to own bonds if they're not attractively priced. We're going to own whatever is out there that makes sense from a risk or or treat and with that portfolio, like kind of generally follow like how your expected returns that chart that we're looking at kind of look like. Yeah. It's going to move somewhat more slowly. One of the things about our forecast is they are value driven. And one thing a value manager can tell you is man value gets you into and out of everything to world. So we rather intentionally move by a slower moving average of those forecasts. And there are some things that we will invest in that we simply cannot forecast. So for example, within liquid all space, one of the things we like today is merger arbitrage. Now I can't come up with a seven year forecast from merger arbitrage. These deals are all either going to complete or fall apart within the next three to 12 months. It doesn't make sense to think about a seven year forecast for an activity like that. But it does make sense to ask the question, are you getting paid adequately for taking the risk of merger deals blowing up? If the answer is yes, this is an interesting asset and we will put it in the portfolio in the last few minutes here while we have you. I wanted to spend some time on some of the research that you have done on private equity. So I know from one of your papers, I think you looked at close to or maybe even over 700, 700 leverage byouts going back to 1981. And what did that research project, what did that actually show that the typical private equity portfolio sort of looked like? Yeah. So for one thing that that analysis was one of those examples of things, artificial intelligence is quite useful for. And we do believe artificial intelligence is useful. You know, one of the things we think about, we talk about super analyst, we talk about, okay, what would you do if you had an unlimited number of investment interests? And one of the things you could do is, all right, look through the last 50 years at all the LBOs that have ever occurred. A useful thing about that for us is we look at the characteristics of publicly created companies. We don't have that kind of detailed information on the privately held companies. But the nice thing about LBOs is their old companies that were once public. And so we can look at their characteristics when they were bought or just prior to them being bought. And so we thought that that was a useful thing to do because lots of our clients have very significant allocations to private equity. They in general understand the fact that that private, qualifier aside, this stuff is equity. And so must embody economic risk. They think they should get paid an equity like return from it. Hopefully more than an equity like return, but they get the fact that this is equity like risk. What they tend not to do is dig further in and say, okay, well, beyond the fact that this is equities, what kind of equities is it? And some things are pretty obvious, even without doing the work. The one group of companies that you could not LBO is giant companies, right? Private equity firms can buy lots of things. They are not going to buy a trillion dollar company. You just can't do it. So we knew before doing this analysis that he was going to skew small, we didn't quite understand how small it skewed. The history of LBOs in the US, there was one LBO that occurred in a company that could have been called mega cap at the time, which was the RJ on the visco deal. Otherwise, it's all been mid caps or smaller and hugely skewing small. So you kind of know that, but when you think about that from a risk and profitability standpoint, one thing that has occurred in the US over the last 40 years is the return on capital of large cap stocks has been on this really nice upward trend. The return on capital of small cap stocks has been a straight line. Now a straight line with a lot of volatility, but there has been this increasing wedge built between the profitability of very large companies and the profitability small cap companies. And a lot of this has occurred. We think because of increasing amounts of monopoly power and just market power among large cap companies. Well, if you can't buy large cap companies, you're not going to benefit from it. So one thing about small caps over the last 40 years, they have gradually had decreasing relative quality versus the market because their profitability has been coming down. Their leverage has also been coming up. One thing that was a little bit surprising to us when we did look at this data, not utterly shocking, but a little bit surprising is that these companies when they were bought were less profitable than them. And they have.
had relatively high amounts of debt. So these companies before they got LBO and were kind of jump. Now on the one hand, maybe that's not a complete shock because private equity says, hey, we can run these companies better. And what kind of company should you be able to generically run better than it was run as public company? A badly run company. So maybe it's not a shock that these companies were not particularly profitable and were reasonably low quality when they got taken out, but it's still pretty striking. And given if for kind of the average and download to foundation in the US, maybe half of their equity exposure is coming from privates in one form or another, that means they have this monstrously large bet in favor of small and in favor of junk within equities. And you probably don't want to have a bias in favor of small. Maybe you could justify it on the back of a hundred years, you could say small as that perform, but on the back of 40 you can. Right. And junky companies have never out before. I mean, they're more volatile. They are higher beta, so they sometimes outperform, but they've got a horrible group to all. So it is not a group you would want to preferentially, oh, and lots of people, I'd have by mistake, have done it. And they can't get out of it now. So the question we are asking or we are suggesting to investors that they might want to ask is, what should they do in their public portfolio to compensate for the biases they're getting in their private portfolio? And then how are you answering that? How are you addressing it? Well, I mean, you can do a few things, kind of in the pure passive situation, you could go long, SMB 500 or SMB 100, and short the Russell 2000, that gives you both the size and the quality of a bias you walk, particularly the SMB 100. And the issue is it doesn't necessarily have a particularly positive expected return associate, and it is going to take a bunch of capital. We do think that high quality companies, particularly if bought with some eye to their evaluation, do perform surprisingly well. So we would argue biasing your report to follow the following towards quality is a good idea. And on the negative side, junky stocks, particularly expensive junky stocks, really do amazingly badly in the long run. So if you've got a bias towards small cap junky stocks in your private portfolio, I'd argue, private is the place you would want to put those stocks, because maybe you can make them better managed in the public portfolio they're a disaster. So kind of going long quality and short, expensive junk, is a nice way to balance some of the risk that is embedded in your private equity portfolio, while generating in the long run at least a positive expected return. - One of the themes of your work is understanding why you should be getting paid on the given asset, that you own. And we were kind of talking about that a little bit before we even started this discussion today, but how would you take that idea and put that to work in today's market? How would you sort of marry those two things right now? - Yeah, so I do think understanding why you're getting paid for the activity you are doing is really crucial. To be clear, it is not crucial because that is the way that is going to get you rich. The way you get rich, the way you massively outperform is by predicting the future better than somebody else or everybody else or just getting lucky. And this doesn't really help you with that. What I think it really can help you with is avoiding doing stupid things. If you've got an activity which you have been sold as an amazing risk reward trade-off. So let's say for example, you've got somebody who's saying, "Man, I can sell you a tail-risk hedging portfolio "that is a cash-like return." Let's say, "Oh, well, I'd rather not lose money in bad time, "so I'd love to have something that gives me a cash-like return "and has that nice kind of correlational problem." That sounds cool. And plenty of people have done it. The vast majority of people who have done it have wound up really disappointed in it. And why? Well, if you stop and think, somebody on the other side has to be willing to put up with this horribly nasty correlated return. I am going to lose a ton of money when the world is falling apart. And in return, I'm only gonna get a cash return. It does not make sense for the person on the other side to continually do that. So you should be really skeptical of someone who is promising you that you can get that lovely return. Same thing, somebody who says, "Man, what you really need to do is just buy call options "on the market because you've got the limited downside "and you've got unlimited upside." Well, somebody's gotta be selling you those call options. And how does it make sense for them to want to sell to put up with that set of returns without getting paid something in return? And so it makes you think, "Oh, well, you know, maybe actually the return "to being long call options isn't gonna be that great "in the long run. "Look and look at that." And when you look at it, you say, "Oh yeah, if you're long call options, "you basically get a cash return." Even though you're getting all that upside because you are just paying enough each time you buy that option to suck out all of the goodness of the stock market. So it helps you avoid expensive mistakes and where you are saying something that kind of requires investors to be a little bit odd, right? I'm saying low quality companies under performant long run. Oh, that's a little weird. They have more downside at the bad times, right? Highly volatile companies that have levered balance sheets are more likely to go bust in the bad. So you should get paid for that. So if I'm going to say, I think this group of stocks underperforms the long run, there's two things I need to do. What is I need to see? Yes, they are priced in such a way that they are going to underperform, that the return from their fundamentals is going to be disappointed. And I need to be able to look at any given time or they still price that one, right? Because any horrible group of stocks if price cheaply enough becomes a wonderful group of stocks. And it helps you understand like value. I love value from a conceptual basis, but value stocks can become overvalued. And there is nothing more supremely useless than overvalued value stocks. They are something that has no virtue when you report quality or whatsoever. So by kind of asking these questions, I think you can avoid doing some very damaging things. Isn't the secrets to success, but I do think it can keep you out of a lot of painful kinds of failure. Excellent, excellent discussion, Ben. Thank you very much for joining us. We really appreciate it. Yeah, it was a lot fun. Thank you. Thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the access returns network at accessreturnspod.com. If you have any feedback or questions, you can contact us at
[email protected]. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.
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