Best of The Long View: Investing

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On this week’s episode, we’ll feature some of our favorite clips from interviews we’ve done with portfolio managers and other investment specialists over the past year. It’s the companion to last week’s “Best Of” episode, in which Christine compiled some of her favorite moments from conversations we’ve had with financial planners, advisors, and retirement researchers.

“Bill Bernstein: Revisiting the Four Pillars of Investing,” The Long View podcast, Morningstar.com, July 11, 2023.

“David Giroux: ‘I Want to Look Forward, Not Backward,’” The Long View podcast, Morningstar.com, Oct. 3, 2023.

“Bill Nygren: The State of Value Investing Today,” The Long View podcast, Morningstar.com, Aug. 15, 2023.

“Michael Santoli: Decoding ‘an Indecisive Market,’” The Long View podcast, Morningstar.com, Sept. 26, 2023.

“Rick Rieder: Explaining the ‘Polyurethane’ U.S. Economy,” The Long View podcast, Morningstar.com, Aug. 22, 2023.

“Jeffrey Kleintop: What to Make of ‘the Cardboard Box Recession,’” The Long View podcast, Morningstar.com, Oct. 17, 2023.

“Katie Nixon: Bringing a Blurry Market Into Focus,” The Long View podcast, Morningstar.com, Aug. 29, 2023.

“Martin Lau: Revisiting the Case for Investing in Chinese Stocks,” The Long View podcast, Morningstar.com, Sept. 19, 2023.

“Jeremy Schwartz: Why Stocks Are Good Inflation Hedges,” The Long View podcast, Morningstar.com, June 13, 2023.

“Joel Tillinghast: The Art of Investing,” The Long View podcast, Morningstar.com, May 30, 2023.

“Aswath Damodaran: A Valuation Expert’s Take on Inflation, Stock Buybacks, ESG, and More,” The Long View podcast, Morningstar.com, May 16, 2023.

“Liz Ann Sonders: Navigating a New ‘Temperamental Era’ in Markets,” The Long View podcast, Morningstar.com, May 2, 2023.

“James Choi: How to Improve the Way We Present and Make Investment Choices,” The Long View podcast, Morningstar.com, April 4, 2023.

“Lubos Pastor: ‘Judging Fund Managers by the Company They Keep,’” The Long View podcast, Morningstar.com, March 7, 2023.

Transcript

(Please stay tuned for important disclosure information at the conclusion of this episode.)

Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services. On this week’s episode, we’ll feature some of our favorite clips from interviews we’ve done with portfolio managers and other investment specialists over the past year. It’s the companion to last week’s “Best Of” episode, in which Christine compiled some of her favorite moments from conversations we’ve had with financial planners, advisors, and retirement researchers.

Earlier this year, we welcomed author and financial historian, William Bernstein, back to The Long View. This was Bill’s third appearance on the podcast, the occasion this time being the publication of an updated edition of his popular book, The Four Pillars of Investing. During the conversation, we asked Bill about a concept he touches on in the book, the distinction he draws between shallow risk and deep risk, and how investors should manage those risks.

William Bernstein: Shallow risk is what we saw in 2008-09. It’s what we saw in 2020, where you see sharp market breaks that don’t produce any long-term damage. A deep risk, as you might imagine from the name, is something that produces a large fall in value, a large fall in real value that lasts for a generation or more. And the two biggest examples you can think of that’s happened with has been Japan since 1990. But what people forget is we also saw that in the U.S. with long bonds between 1940 and 1980, when the dollar invested in long-term government bonds, even with reinvested dividends in 1940, fell to one third of its real value by 1980. That’s deep risk. So, how do you mitigate that?

You have to look at financial history and ask yourself, what are the real sources of deep risk? And there are a number of clauses, and I list several of them in a couple of my books, including this book. But the biggest one by far statistically, or the most frequent one, is going to be inflation. Inflation is basically a phenomenon in almost all countries. The only country that I can think of that hasn’t experienced a large amount of inflation in the past 100 years has been Switzerland.

So, how do you protect yourself against inflation? Well, for starters, you keep your bond duration short so that when rates rise, you can roll them over at the higher rate. And stocks, although stocks don’t do well initially with inflation, what you see is that over the very, very, long term, they do. So, if you look at countries, particularly in Latin America or in Europe post-World War II that had high inflation, stocks did pretty well in the long term. The most spectacular example of that was the Weimar inflation, the wheelbarrow inflation from 1920 to 1923, that four-year period when prices rose by a factor of 1 trillion. That’s trillion with a T. Well, it turns out that German stocks did just fine during that period. It was a wild ride. But for those four years, they actually had a positive inflation-adjusted return.

I’ll say something else about stocks as a hedge against inflation, which is that value stocks are a particularly good hedge against inflation. Because if you think about it, inflation melts away the real value of a company’s debt, and that flows directly to its real bottom line. Then, finally, I like the stocks of commodities-producing firms. I don’t like commodities-futures firms for a number of reasons that are pretty arcane. And they’ve not really done very well over the past couple of decades because of that. But the stocks of commodity-producing firms, although they correlate more highly with the stock market than commodities futures do in the long run, I think they’re a better hedge against inflation.

Ptak: We also welcomed back David Giroux. David is the manager of T. Rowe Price Capital Appreciation Fund and has racked up a very enviable record in his nearly two decades at the helm. During our chat, we asked David to reflect on his early days running the fund and what advice he’d give his younger self if he were able to go back in time.

David Giroux: I’d probably highlight three things. I think I would say, one, you try to understand where the market is structurally inefficient and ruthlessly exploit those inefficiencies. We, over time, identified 17 structural market inefficiencies in equities and fixed income that we exploit day in, day out. When I started as a PM, I really didn’t understand these inefficiencies. I think I was really trying to play the same game everyone else was playing. I’ve really come to believe that when you’re playing the same game as everyone else, it’s really a losing game. So, I’d say that’s one.

Second, I think I would tell myself to work more closely with the quantitative resources at T. Rowe earlier in my career. I really didn’t do anything on that front really until late ‘09. I joke with people internally. There was a BFS era, before Farris Shuggi, and AFS, after Farris Shuggi, period at CAF. I’ve worked very, very closely with Farris Shuggi and the rest of the quant team at T. Rowe on so many proprietary projects over the last 14 years that have really meaningfully, positively contributed to CAF’s performance. Honestly, it changed the way I managed CAF for the better over time.

The third thing I’d just highlight is just make sure you have strong processes in place. And that means IRRs, reports, analytics, really robust risk management from day one. So, I’d just highlight those three things.

Ptak: Portfolio manager, Bill Nygren, also paid us a repeat visit this year. He was one of our first guests back in 2019. And so, it was great to have a chance to catch up with him about what he’s seeing in the stock market through his lens as manager of various value-oriented Oakmark funds. Bill is an accomplished bottom-up stock-picker, and we spent a lot of time delving into the stocks he owns. But we started our chat by asking him why it’s so hard to invest based on macroeconomic forecasts.

Bill Nygren: Well, there are a couple of reasons. One, the market always anticipates. And I think as a rule of thumb, you think of the market looking at least six months ahead. So, just on that basis, you would expect that by the time you’re hearing on the news or reading in the paper that we’re in a recession, we’re in a bear market, inflation has gone crazy. By the time you’re hearing that in the media, it’s generally too late. I do a quarterly commentary piece on our Oakmark.com website. And I wrote about this about a year ago when everybody was panicked that all over the news media was we’d entered a bear market, the S&P was down 20%.

And we actually went back and looked on all three of these measures—bear market, high inflation, and recession—what would actually have happened if you invested in stocks after the market had fallen 20%? What would happen if you invested after two quarters of down GDP? What would happen if you invested after inflation had exceeded, I think, 7% was the number that we used? And on all three of those, the median performance that you would have achieved after the news was known was actually a little bit better than average. And I’m not really trying to argue that it’s statistically significant that it’s better than average, but it certainly wasn’t worse. And especially for individual investors who just hear that drumbeat of we’re in a bear market, you better be careful what you’re investing in, I think it’s really important for them to understand investing just doesn’t work that way. By the time the news is out, it’s too late.

The only time I can remember in my career where that wasn’t the case was the housing collapse in 2008, which was the precursor of the great financial crisis. We had looked at that time period and said the same thing. We’re reading this in the newspaper. Historically, we’d never seen a meaningful decline in residential home prices. It must be too late. And over my 40 years, that was the one time that you actually could have invested pretty well having already read it in the paper. But I guess that’s the exception that proves the rule because most of the time it doesn’t work like that.

Ptak: CNBC senior market commentator, Michael Santoli, is also no stranger to The Long View. We interviewed Michael for the second time this year. And as was true the first time we chatted with him, we’re impressed by his ability to distill broad market trends in ways that are practically useful to the average investor. In this case, where we asked Michael about what artificial intelligence could mean for labor productivity, he did what too few strategists do. He said it was hard to tell and we need to wait and see, which itself is valuable.

Michael Santoli: I would suggest that it’s just way too early in this AI-buildout investment process for the markets to confidently handicap and price in any productivity gains that we get from it. I come at the AI story as a whole with a pretty high burden of proof to me that this is something more than, guess what, software gets better, smarter, faster all the time. And that’s generally what has happened forever. And maybe we’re in an accelerated moment where it’s happening much more rapidly to much more tangible effect. But right now, if I look at the way the stock market is capitalizing this opportunity, it’s mostly about a hardware buildout of capacity in AI and data center investments that have to happen to the benefit of those people selling those actual tools and chips.

And we’ll see later if this is all money well spent. We’ll see later what the economic payback is off of this in terms of productivity. I have no doubt that it’s probably going to be that. But right now, it’s much more about people spending in an urgent way because they feel compelled to do so because the opportunity might get away from them or they may be disadvantaged. So, I think it’s just too early for us to say productivity is going to have this step function higher and therefore that’s disinflationary and all the rest of it.

So, it is also one of those things where productivity is—it’s a residual number that comes from other calculations. I don’t know. I have a little bit of skepticism about it. And it’s also why this is a funny moment in macro in terms of trying to really discern what’s happening because we’re at this time of the conceptual theoretical variables like real rates, like potential growth, like the neutral rate of interest, like long-term productivity gains where it just feels as if it’s not very here and now. It’s not the absolute cost of money. It’s not the absolute growth of the economy in nominal terms. And I’m not saying those are wrong or false. I just find it difficult to believe that the market has a handle on any of those things in the moment.

Ptak: Rick Rieder also made an encore appearance on The Long View as our guest. Rick serves as BlackRock’s chief investment officer of Global Fixed Income, in addition to other leadership responsibilities at the firm. It’s certainly been an eventful few years in bond markets amid fluctuating interest rates and the shift to a postpandemic economic regime. We asked Rick why the economy wasn’t doing worse than it was given all the cross currents, including monetary tightening, a moribund housing market, and stubbornly high inflation.

Rick Rieder: I think the U.S. economy is one of the most extraordinary economies in the history of how people think about business structure and about how the world works from a commerce point of view. I did a presentation where I called the U.S. economy the polyurethane economy, meaning it’s so flexible, so adaptive. When you think about those Tempur-Pedic beds, when one side of the bed has volatility, the other doesn’t necessarily have that. And I quite frankly think that is the case here in the U.S. economy. It’s 70% services, 70% consumption. Services don’t really go in a recession. Think about how people spend on healthcare, education, and so on. It doesn’t really go in a recession. It’s so different than 20 or 30 years ago when you had a commodity-oriented economy that was spending an awful lot, and manufacturing was driving the economy. You could have big cyclical evolution. The U.S. economy today is much more stable.

And then, you break it down and you think about it’s an economy that has energy independence, spends a tremendous amount on R&D and tech, and quite frankly, also has brought the debt down, which seems inconceivable when you say that because when people look at the size of the government debt. But the way economies work is there are four parts of your debt structure. It’s your private, it’s your household, it’s your corporate, it’s your financial, and then it’s the government. You think about what’s happened over the last few years. Households have deleveraged financials, particularly big financials have deleveraged, and corporates have extended their maturity and have brought down some of their leverage. So, it’s just the government that holds the debt, meaning the stability of the economy, even when interest rates grow, is not that significant. Anyway, I think people will continue to question, is the economy going to go into a recession? And you just have this immense amount of growth. Nominal GDP in 2021 was 12.3%, in 2022 was 7.3%. If we went into two quarters of negative one, the economy is still operating at an incredible level. So, I think the economy will continue to confound people for a long time.

Ptak: We welcomed Schwab’s chief global investment strategist, Jeffrey Kleintop, to The Long View for the first time this year. Jeffrey makes his living in the torrent of macroeconomic and markets data that comes our way. We were curious to know which data points or measures he’d tell inquiring friends or family to pay attention to.

Jeffrey Kleintop: I guess I have a reputation as someone who pushes to find the truth in data. Often, I find, in maybe nontraditional measures, I find more comfort in things that just make sense to me. Like the downturn that’s currently indicated in official manufacturing and trade data. Some of that’s kind of abstract. I find comfort looking at the plunging demand for cardboard boxes. I’ve been referring to this as a cardboard box recession because things that are manufactured and shipped tend to go in a box and because demand for corrugated fiberboard, which is what most cardboard boxes are made from, has fallen just like it did in past recession. So, literally, cardboard boxes are in a recession. So, things like that make sense to me. The truth is out there. What was that, The X-Files or something? “The truth is out there.” Meaning, you don’t have to rely on official sources for data. Those are helpful, but you can often find it in things that just make sense. The internet is an amazing tool and so much of it is available to all of us.

China is a difficult economy to measure. I often get asked, are they lying to us? No, I don’t believe so. I think they just don’t have good tools or practices or incentives to measure things as accurately as we would like them to. I find that air pollution, which is something that is … A gauge of air pollution is done in every one of the major cities in China by U.S. State Department officials at the various consulates in China. I didn’t know this until I went there and met with some State Department officials. Every hour they do EPA air-quality tests. And so, I can see on a real-time basis, NO2 emissions, particulates. These things tend to correlate very closely with economic activity in China because a lot of manufacturing is so dirty there and transportation. So, I found that is a really good real-time way of measuring what’s actually going on on the ground in China.

So, sometimes it’s putting together a lot of these things that just intuitively make sense. And I think often we tend to fall back on official pieces of data. But what I’m paying attention to isn’t always evolving. I think if you’re looking at the same things you were looking at 10 years ago, you may be missing what matters today. It’s a totally different cycle, right? Inflation, interest rates, geopolitics, valuations, fiscal policy in Europe, drivers of growth in Asia. So, I’m always looking for finding the truth in data, but often that’s nontraditional data.

Ptak: We put a similar question to Northern Trust’s chief investment officer, Katie Nixon. We wanted to know what she’s found is truly helpful to advisors and clients who are trying to make sense of the environment around them amid a swirl of macro research events and data, and on the flip side, what’s counterproductive.

Katie Nixon: Those are two great questions, because it’s almost more important to know what’s counterproductive. But first, let’s start with the positives. I think clients want to be reassured, but they don’t want to be misled. You can’t whitewash the truth. So, I always say, be honest and use data and really use visuals to make your point as an advisor. How has the market downturn impacted them, if it has? What are some of the decisions that they may want to make or need to make? Clients want collaboration. They want to be part of the process. And honestly, this should come as a relief to advisors because we don’t have to know the answer anymore. It’s all about just outlining possible outcomes as well as trade-offs and helping clients make the best decisions given everyone’s inability to really predict the future.

Now, as an aside, I will say also that advisors have to absolve themselves of feeling the pressure to have to predict with perfect precision the future. At Northern Trust, we say, “prepare, don’t predict.” And at the end of the day, honestly, clients just want to know that you understand them, that you’re helping them to make good decisions based on your framework, your data, and your expertise. So, that’s what they need to know.

What is counterproductive? I think—and this is from decades of experience and having done this many, many times counterproductively—I think data overload, information overload, extraneous or irrelevant information, these are all very counterproductive. And I think back to that “predicting the future” comment I made earlier, suggesting that you know what’s going to happen with rates or the market, with the Fed or China, whatever—that’s just a mistake and it’s very counterproductive. Of course, we always have a base case. We all have a forecast. We have perspective on what’s going on in the world and that can provide some foundation, some grounding. But it’s a pretty deep and dark rabbit hole to go down when you make swings in client portfolios based on a short-term outlook. So, I would really avoid the tactical perspective, the short-term tactical action-oriented perspective. That’s pretty counterproductive, particularly when you’re trying to fund clients’ goals over the long term. And also, I guess I’ll say something that’s probably really obvious to your audience, but I’m going to say it anyway, and that is, just avoid industry jargon, acronyms, and so on. Those are all very counterproductive and that will definitely get your clients’ eyes glazing over very quickly.

Ptak: Chinese stocks have struggled mightily in recent years amid government crackdowns and tumult in the banking and property sectors. The question some investors are grappling with is whether the Chinese market is a screaming bargain or a falling knife. We put that question to returning guest Martin Lau, who’s a managing partner of FSSA Investment Managers and portfolio manager of several China-oriented FSSA Equity strategies. After asking Martin what had gone wrong in the Chinese market, we pivoted to ask him whether he’s as optimistic about the stocks now as he was when we first interviewed him in 2021.

Martin Lau: Yes, we are. I think there need to be a few things that—when an investor decides to invest into China today, I think they need to accept—and that has always been our view that China is no longer the kind of high-growth country that we talked about 10, 15 years ago, maybe 20 years ago. If you look at China today, it’s actually already the second-largest economy in the world. And if you think about why people are concerned about China, let’s say if you have your Evergrande and your Country Garden and some of the developers having liquidity problems, it does reflect certain structural issues in China. In this case, the leverage in the system is actually quite high. So, if you have the second-largest economy and already reasonably leveraged, I think one should really expect the slow growth to be the norm.

I think whether it’s 5% or 4%, 3%, we never quite pay attention to the official number anyway, because we believe that’s only an official number. But then, the other thing, I think for the optimism. As a bottom-up investor, which we are, it’s really about the growth opportunities or the exciting companies, which might happen even with a slower economic growth. In fact, I would probably go even further as in, let’s hypothetically say, if China does have, let’s say, 3% to 4% or 5% growth for the next five years, in my view, it’s actually quite good. It’s definitely not the end of the world. And the reason for that is that only if … For many, many years, whenever we travel in China—and this is a real story—we have a company telling us, “By the way, there’s really no point of innovating.” And we said, “Why?” And they say, “No matter how much you’ve tried hard, the profit is not sufficient to buy a property in Shenzhen.” So, when the property price is not going up and the economic growth is more sluggish, in a way it forces companies to think differently. And I think this is one of the things that we are really watching out for in China as in how companies’ behavior with regards to their efficiency, cost management, mentality, balance sheet management, how you return cash to shareholders possibly. And these things matter. I think if you look at, let’s say, the U.S., or U.K., or even Japan, I think a lot of companies have done well not because the economy has done well. It’s really the way that they do things have gradually evolved. And this is what we want to find out, which companies do have those characteristics in China rather than taking a view as whether GDP growth is going to recover from 4%, 5% to maybe 6%, 7%. If it happens, it’s great. But that’s what we look for from companies.

Ptak: Inflation dominated the headlines this year with the Fed raising rates to subdue it while market participants nervously looked on. We were fortunate to interview Jeremy Schwartz, global chief investment officer for WisdomTree Investments, as he and Jeremy Siegel conducted research on the relationship between stocks and inflation for Siegel’s influential book, Stocks for the Long Run. We asked Jeremy what made stocks the best long-term inflation hedge that money could buy.

Jeremy Schwartz: And you see that this year with all the inflation that’s in the system, you tend to see companies raising prices. So, they’re passing along price increases. They’re even sacrificing volume. One of my friends is using the term “price over volume.” You see it in a lot of the earnings reports that companies are pushing price and even sacrificing volume. And that goes to, over time, companies are really good long-term inflation hedges. And as you say, in the book we show that long-term real return to stocks, that real return is after inflation. That 6.7% we quoted very early on when we talked about capital market expectations, 6.7% was the return above inflation. So, if you go back in Siegel’s 200 years of data, the first 130 years, there was basically no inflation. And then, you’ve had 70, 80 years of inflation. And over the 200 years, inflation has been down about 1%, but over the last 80 years, there’s been inflation about 3%. And what you find is that the real return to stocks was basically over the very long periods the same exact with inflation as when there was no inflation. So, you didn’t see your real return go down at all with the inflation that we’ve experienced.

Bonds, by contrast, historically didn’t have any inflation-adjusted bonds. The real risk to bonds was that there’d be higher inflation and that the coupons wouldn’t offset that. But in the short run, when the Fed starts battling inflation and hiking rates like they did last year—last year was a bad year for both stocks and bonds, first bad year for stocks and bonds in a very long time. In the short run, as the Fed starts fighting, it can be painful for stocks. But over the long run, as you see companies pass along price increases, they’re what we call real assets, they tend to grow earnings and dividends along with inflation. If you go back to that original S&P study that we started the interview with, the S&P dividend growth since 1957 has been about 2% on top of the 3.7% inflation. So, you get real growth on top of the inflation hedging that you get with the fundamentals offsetting that. And so, that’s part of why we view stocks as the best long-term inflation hedge.

Ptak: The word “legendary” can get thrown around pretty loosely in investing circles, but the adjective definitely fits retiring Fidelity manager, Joel Tillinghast. Joel has managed Fidelity Low-Priced Stock Fund since 1989, amassing a remarkable record over his long and distinguished tenure. And he’s done it his own unique way, spreading assets across hundreds of names that he tracks. Here, he addresses my colleague Adam Fleck’s question on how he strikes a balance between spreading out among smaller companies he thinks present compelling value versus diluting his best ideas.

Joel Tillinghast: Every stock that gets purchased has something intriguing. It’s usually statistically cheap valuation or a differentiated competitive position. Sometimes more rarely, it’s just a management team—wow, they’re good. I buy incrementally. I don’t think that I’ve ever bought—except maybe on an IPO or a deal—25 basis points of one security in one order, or it’s a very short list. It’s usually incremental where I add more as there’s more information. I use the small holdings to level-set for subgroups so it can spot the most appealing holdings in somewhat homogeneous groups like energy or banking and maybe retail. I try to narrow the field, but also to level-set. This is what a regional bank looks like and this is what a better regional bank looks like. I try to migrate toward the better ones in the group. And it’s shades of gray, because all the banks make loans—except maybe Silicon Valley Bank, so they did do that, because that also got them into trouble. All the banks take deposits and so what’s a good bank? Well, the income is good, but that can be cyclical. So, it helps me level-set. Am I diluting the holdings? If you compared the largest 10 holdings in the fund, they are c cap, but the weightings of low-priced top 10 are probably the same or higher than many small-cap and mid-cap funds. If I think a stock is great, it’s not diluting it; it’s part of the process of sorting out what does a good bank look like? What does a good energy company look like? And they want it to be bet on this is a good energy company or a good bank rather than gas prices are going up, they’re going down; interest rates are going up, they’re going down.

Ptak: Yeah, the nature of long-term holding—certainly I think that’s really important. That’s a very fair point.

Tillinghast: They were worried that it was diluting the best holdings. Actually, I do think that at the top it’s more concentrated than many small-cap funds, mid-cap funds.

Ptak: The annual Morningstar Investment Conference is always a highlight of the year for Christine and myself. We were especially fortunate this year to chat on-site at the conference with two luminaries, eminent NYU finance professor, Aswath Damodaran, and Schwab’s longtime chief investment strategist, Liz Ann Sonders. In our first conversation with Professor Damodaran, we asked him to dispel some of the common myths that surround share repurchases, starting with the misconception that they are a more tax-efficient way to return capital to shareholders than dividends.

Aswath Damodaran: They’re mildly more tax-efficient now, but the difference is not like it used to be in the 1960s and the ‘70s where dividends were taxed at rates almost twice as high as capital gains. That’s no longer the case. So, if there’s a tax advantage, it’s far smaller. The primary tax advantage from buybacks now comes to the fact that you have a choice. You have a choice of selling your shares in the buyback and paying your capital gains tax or accepting price appreciation and paying in the future period. And that might be valuable to people, but it’s not the tie breaker it used to be, it’s not of the magnitude it used to be. So, that’s the primary tax efficiency argument. That could be offset very quickly by the change in law this year with a 1% tax that companies have to pay on buybacks that can more than wipe out whatever the tax benefit is. But I think we’re going to find out that that doesn’t stop buybacks because that’s not the prime reason driving the buybacks.

Ptak: One of the prime reasons I think that you’ve cited is the optionality that it gives to the company, whereas with a dividend it’s somewhat irreversible. With the buyback, you have the ability to ratchet it higher or lower depending on conditions or what your imperatives are.

Damodaran: It’s flexibility, yes, exactly. And basically, the way I describe it, the more uncertain companies become about future earnings, the more difficult it becomes to start paying dividends. Because the problem with dividends is, once you start paying them, you are expected to keep paying them. To me, dividends have always struck me as unsuited to equity. Equities are residual claim. You get whatever is left over. How can that claim be guaranteed for the next 20 years? So, I think, in a sense, the more concerned companies collectively get about future earnings, the more you’re going to see cash return in the form of buybacks, which is exactly what’s happened in the U.S. and it’s increasingly happening across the world. Last year, more than 51% of the cash return by Canadian companies came in the form of buybacks. Last year, 36% of the cash return by European companies came from buybacks. This is not just a U.S.-centric phenomenon. This is a global phenomenon of moving away from rigid dividends to more flexible buybacks.

Ptak: Before we move to ESG, maybe if I could just follow up. Probably the most politically charged of the criticisms that are levied against buybacks is that they stifle reinvestment in the business, so basically, resources that could be directed toward more profitable uses or those that are thought to be more employee-friendly, instead, the money goes toward share repurchases. What’s your take on that?

Damodaran: Let’s take the employee-friendly part, that’s a different issue. On the stifling reinvestment, good. I’m glad they stifled reinvestment in some companies. Do you want Bed Bath & Beyond to have opened 50 more stores in 2008 and 2009? You want GE to pump another $100 billion into businesses where you’re not going to get the cash back? This notion that reinvestment is better than returning cash is a nonsensical one. Because there are some companies—in fact, there are quite a few companies—that should not be reinvesting anymore. And the cash returned is being reinvested elsewhere, right? It’s being put into other companies. So, the question is not whether you should reinvest your returned cash, but whether the reinvestment should be done by, I don’t know, Caterpillar, or whether it should be done by Nvidia. And I think that’s a choice you have to make. Where would you rather have reinvestment? In old businesses, which are dying—more tobacco, more chemicals, when nobody’s buying them, or in newer businesses where there’s a chance for growth? So, I think it’s a very dangerous argument because it’s disingenuous, because it basically makes a presumption that the trillion dollars that was spent on buybacks last year just disappeared into a black hole. Think of what this market would look like if that trillion dollars had not been out there to be reinvested in other companies.

Ptak: In our conversation with Liz Ann Sonders, which took place on the main stage at the Morningstar Investment Conference before a live audience, we asked what it would take to bring the housing market back toward equilibrium, where housing affordability was less of a challenge due to rising mortgage rates and stubbornly high home prices.

Liz Ann Sonders: Housing affordability really is a three-legged stool. There are three main components of housing affordability. Obviously home prices, income, and then mortgage rates. And for a while there all three of the legs were knocked out from under the stool. You had the spike in mortgage rates. You had income going down, particularly real income courtesy of inflation, and you had home prices that were incredibly elevated. You’re right, Jeff, to point out that home prices haven’t compressed much at all. Home sales, the combination of existing and new-home sales, I think peak to trough down around 40% this cycle. That’s not the 50 and change that was the case in ‘06, ‘07. But when people say, well, home prices are only down a couple percent, how can you call it recession? Home sales are down 40%. I think that’s probably in anybody’s thinking of what might define a housing recession.

I’m not sure that prices are going to collapse because of the supply/demand imbalance. It is the case, and this more is a tie into potential problems for certain types of operators and banks, but the supply of multifamily homes coming on the market this year is massive, like a record.

So, we’ll start to ease some of the supply constraints on the multifamily side. But there’s a way to go to solve some of those constraints on this single-family-home side of things. So, it’s also the case that with this recovery we’ve started to see in housing—we’ve seen the NAHB Housing Market Index lift up off the bottom, the latest data has generally been a turn back higher, sales have picked back up. Even saw a little bit of an uptick in certain regions and prices.

I’m not suggesting it’s going to be a short-lived rally but a lot of this housing data goes back decades and decades, so you can take a long view, every time you’ve been in a Fed-hiking cycle and housing has struggled, which it always does, when the market, the overall market, the housing market has in its sights the pause, the terminal rate—OK, they’re almost done—housing has always rallied. In soft landings, it continues to; in recessions, it rolls back over, so maybe you’d think of it at the other way. Keep an eye on housing because it may be kind of a tell on recession risk. If this is just an attempt at a rally, a last gasp before the next let down. All that said, this is not a weight in any way, shape, or form, either, for the banking system or housing.

Ptak: We’ll finish this “Best Of” with a few snippets of thought-provoking conversations we were fortunate to have with some leading lights in the field of academic finance. First is our chat with household and behavioral finance researcher, James Choi. Dr. Choi is a professor of finance at the Yale School of Management, where he’s done influential research on automatic enrollment into retirement plans. We asked Dr. Choi for all the progress that has been made in getting employees to participate in employer-sponsored retirement plans, where he thinks there’s still room to improve employee participation in overall retirement preparedness.

James Choi: I think that there are probably two things I would think about. One is on the early withdrawal margins. So, we know that a huge amount of money leaks out from the retirement savings system before the age of 59.5. We know this from IRS tax records that people are withdrawing this money well before retirement. I think that there’s a lot of decumulation that’s happening in ways that I think were not really intended for the system when it was erected piecemeal over the decades. I think there is a serious conversation that we could have about whether we want to plug some of those holes in the retirement savings plan, make the system a lot less liquid. And indeed, if you look across the world at other developed countries, their pension systems tend to be a lot more illiquid than the U.S. system is. So, that’s the one dimension.

The other dimension is that we don’t have equal access to common savings plans across the adult population in the U.S. So, about half of U.S. adults actually don’t have access to a 401(k) through their employer. And there’s not rigorous evidence as to exactly what a 401(k) does for your retirement savings accumulation, because of course, it’s not random who ends up at a company that has a 401(k) plan versus doesn’t. But it does seem reasonable to think that having this mechanism where out of every paycheck a certain amount is deducted and put away in the retirement savings plan is helpful for actually building up some retirement wealth for yourself. And so, I think that for the half of the adult population that doesn’t have this, it would be nice if there were a better mechanism for getting them to participate in the retirement saving system.

Ptak: Well, since you’re mentioning that, do you think we’d be better off if there was a single government-sponsored retirement plan styled after the Thrift Savings Plan instead of the current employer-led patchwork approach that you’ve been talking about?

Choi: I think that if we could run the system as its Platonic ideal was if it was, say, hit or run by the Singaporean bureaucrats, then yeah, I think that would be good. Maybe even run Thrift Savings Plan. It’s actually a fairly well-run plan. So, if that could scale up, then I think that that could be quite a good thing. But of course, whenever you scale things, there are complications and you do have concerns about lack of competition and so on. So, I think the political economy of all that, I don’t have necessarily a strong opinion on.

I think one thing that you have seen that’s trying to increase access and democratize access to the retirement savings system is these automatic IRAs that have been springing up at the state and local level across the U.S. So, what’s happening here is that you do have employers that don’t offer a 401(k) plan. They are now being required to automatically enroll these employees in a payroll-deduction IRA. And so, a portion of each paycheck does go off into an IRA that’s sponsored by the state or the locality. So, I think that this is progress. But what I don’t like about the way that this is emerging is that the system is very piecemeal. For example, in Connecticut, the system is being set up. Connecticut is a small state, and people leave Connecticut. So, what happens to your small-balance auto IRA when you leave Connecticut? Well, you’re not going to get anymore contributions from your payroll deduction going into that account. So, you end up having this small account that is accumulating administrative fees, which might be subsidized by the state but might not be in the long run. And you could have a situation where somebody has five or six of these small-balance accounts just scattered across the nation. And we know that it’s a problem that when this kind of thing happens, people forget. They lose track of their money. And so, what would be a better solution is some kind of national auto IRA, where even if you move from California to Nevada to Iowa, you’re going to be able to keep that same account without going through a lot of hoops and just make that administratively much easier for the individual. But we’re not there yet and Congress has not acted with any kind of speed to create that sort of system.

Ptak: Lastly, we spoke with Professor Lubos Pastor. Dr. Pastor is a finance professor at the University of Chicago Booth School of Business. And he’s conducted research on a wide range of pertinent topics, including the variability of equity returns, the link between ESG and investment returns, active fund performance in different market climates, and more. We asked him here to discuss some of his work on risk factors, starting by defining what a risk factor is, and then to address his research on liquidity as a risk factor.

Lubos Pastor: I think of a factor as an economic variable that moves over time and captures common variation in returns. So, it’s a variable that is correlated with many assets’ performance, with the performance of many assets. Or put differently, maybe slightly more technically, there are many assets that have significant betas, or significant loading, or significant exposures to this variable. So, that’s what I think of as a factor.

You mentioned liquidity as a factor. When liquidity evaporates from the market, many assets lose market value. So, liquidity is highly correlated with asset returns, and we find that that is the case above and beyond any correlation with the stock market as a whole because the stock market also falls when liquidity evaporates. But many assets have a beta with respect to liquidity even after controlling for their exposure to the stock market. So, that’s a factor. I think it’s also very important to distinguish just a factor from a priced factor because not every factor is priced. And a priced factor is a factor that has a risk premium attached to it. So, a priced factor is one where assets that have high betas with respect to this factor have higher average returns going forward. Assets that have low betas have lower returns going forward. And that is precisely what we find about our liquidity factor, that assets that have higher liquidity betas have higher risk-adjusted returns going forward.

Ptak: That’s helpful. Maybe at this point it makes sense to talk about liquidity and how you defined it for purposes of the paper that you wrote and also, maybe how sensitive the findings were to one’s definition of liquidity?

Pastor: Rob Stambaugh and I designed this liquidity factor many years ago, I think 20 years ago. And we measured liquidity at the individual stock level by essentially trying to measure price impact. Because we believe that that’s the dimension of liquidity that matters the most to institutional investors. How much do you move the price when you trade a given amount? Specifically, we designed a regression model where we asked, suppose you trade $1 million worth of a stock; you move the price, and we ask how big is the reversal after that price impact the following day? So, the idea is if you sell $1 million worth of the stock, you depress the price because some market maker has to provide liquidity. They have to get compensated. So, the price drops temporarily. But then there will be a reversal going forward so that the market maker can actually get paid in expectation for providing liquidity.

We measure that temporary reversal in price that results from a $1 million trade. And then, we average this quantity across many stocks, across all stocks that are trading in the marketplace to get a marketwide measure of liquidity. And when you plot it, it looks like liquidity. Most of the time, it’s just fine. It’s not doing much. But now and then, it dries up. Now and then, there’s a spike in liquidity where liquidity evaporates from the market. These are moments like October ‘87, ‘98, 2008. So, that’s what we do.

You also asked about sensitivity to other definitions of liquidity. We haven’t really tried many in the paper. We’ve tried a few to show that they don’t work. It’s very important what you use as a measure of liquidity. Some obvious candidates are not very good when you’re trying to construct the liquidity factor. So, for example, people like to use trading volume as a metric for liquidity. The idea being when there’s a lot of trading, liquidity is high. And I think that’s a good idea if you’re looking across assets. But it’s not a good idea to do this when you look across time. Trading volume is not a good measure of liquidity over time. A perfect counter example is October 1987 when we had a total evaporation of liquidity and yet we had a record high trading volume in the market. So, price impact was very high; at the same time, the trading volume was very high. It was basically one-sided volume. So, long story short, it actually matters a lot how you define liquidity and if you do it the way we do it by looking at price impact, then you find that liquidity is priced.

Ptak: That wraps it up for this “Best Of” episode. We hope you enjoyed it. On behalf of the whole team at The Long View, wishing you and yours happy holidays and a healthy and prosperous 2024.

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