Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance and retirement planning for Morningstar.
Jeff Ptak: And I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Ptak: Our guest this week is Meb Faber. Meb is co-founder and chief investment officer of Cambria Investment Management, which manages ETFs and separate accounts. In addition to his duties at Cambria, Meb is a prolific author who has written influential books on tactical allocation and endowment-styled investing, among other published works. He also hosts the popular Meb Faber Show podcast, is an active participant in financial Twitter at @MebFaber, and is the architect of The Idea Farm, a web-based research resource he developed for investors. Meb is an experienced angel investor in small, private businesses as well as an investor in alternative assets like farmland and rare coins. He graduated from the University of Virginia with a dual major in engineering science and biology. Meb, welcome to The Long View.
Meb Faber: Wonderful to be here. You all host one of my favorite podcasts. So, it's an honor.
Ptak: We just gave people your bio, but it doesn't really do you justice as you are kind of a renaissance man involved in many different investments and ventures. Given your wide-ranging interests, how did you decide investing would be your area of professional focus?
Faber: Oh boy, I don't think I was born with it, like Buffett talks about with his value-gene inoculation. I came from a family of engineers, kind of a science background. I studied biomedical engineering in college. But, if you remember, I graduated in 2000. So, if you recall that was not only a massive U.S. stock bubble, but also in biotech. So, it was Internet, dot-com names, but also biotech stocks. And I went to Virginia--right down the road was where the genome was getting sequenced at both NIH at the government, as well as Celera, Craig Venter's company. And so, I had one foot on each side--I was kind of the nerd that had all the annual reports in my dorm room, but also was interested in biotech as well. And when my father passed away a handful of years ago, we actually found an old postcard that I used to write to him. A postcard, for younger listeners, is something you send in the mail. It's a physical card, it's like an email. But in it I was talking about investing and actually talked about ideas for stocks, like McDonald's, Disney, Coke, and Anheuser Busch of all things--I think I like Spuds MacKenzie. So, it was from an early age--curiosity, and then over the years, my career diverged from biotech and engineering and more toward investing and the hobby became the career and vice versa. There's a little ski-bum period mixed in, too.
Ptak: Did your exposure to biotech influence you to want to invest in that sector when you were just starting out? Or were you always thinking about investing in a broad basket of stocks across sectors?
Faber: I look back at the ‘90s, and I see a lot of the behavior today in me back then. And I imagine I would fully be caught up in a lot of the speculation going on today. And that's not shaming people. That was me 20 years ago, and for me, it was biotech and investing in a lot of the high-flying Internet names. But I think it was both--I think I had a curiosity and wonder about the science. What's more interesting about sequencing your genome? Here we are 20 years later, you can get a 23andMe and find out you actually have some genetic exposure to being Australian or part Japanese, whatever it may be. And you find out that you have these various traits, it's almost like Gattaca coming to life. It's so exciting. And the good news is all these therapies are actually coming to market. But I learned a lot--the aftermath of that bubble, a lot of investments declined 60%, 80%, 90% on both sides. You could have these great companies, but the distance between a stock and a business was a big lesson to learn.
And I think I'm grateful for all the scars. I learned to all the behavioral biases that had been written about over the years by Thaler and Montier and others. I had them all; I was overconfident, I would take as much risk as you could give me, on and on and on. And I think learning those lessons, thankfully at a young age with not a lot of money, crafted my investment philosophy over the years and also inoculated me with a huge amount of humble pie as well.
Benz: It makes me think about this current period that we're living through where you've got a lot of young people who are gravitating to trend-chasing, for lack of a better term. Do you think that that sort of experimentation is a necessary step for us as investors for our evolution as investors, or can some people just skip over that and move straight to index funds or ETFs, or some other sort of more sober way of pursuing investing?
Faber: God bless the ones that can skip over it. I think it's hard. I think if you look at our genetic disposition, as emotional human beings, we weren't evolved to run toward the lion on the Savannah. And so, we have all of these innate characteristics that are not setting us up to trade shares of IBM, or Robinhood, or REITs, or currencies, or crypto, or on and on and on. And so there's a couple ways to go about it. One is, I think any great investor has to be a student of history, to at least give you a baseline understanding of what has happened in the past. I talk a lot about this. But my favorite book being Triumph of the Optimists, looks back at equity and bonds and bills markets over the last 120-plus years, and what has happened. And some of the countries that have done amazing and hyperinflations, and some of the countries that have packed up and gone to zero.
Having that appreciation of history gives you a guide with the foreknowledge that the future will always be different, the market will always surprise us. Even in the last few years, we've had a couple of things that have never happened before. 2017 had the longest run of up months in the stock market in a row; you never had a calendar year where the stock market was up every year. So that was new. Just last year, pandemic--fastest ever, from all-time high to bear market and vice versa. You have to have an appreciation, almost like a comedian, that things will be different in the future.
But even then, it's hard to describe to someone what it's like to go through without having been through it. Buffett and Munger talk a lot about this. They say, "We've seen our portfolio go down top to bottom 50% more than three times, and unless you can sit through these…" And that's the hard part--the emotional inflection--I think it happens around minus 20. So minus 10, people start to get nervous, stomach maybe turning upside down. Minus 20 is really where the kink happens. And I think it's almost like the Richter scale on earthquakes-- every 10% after that, it gets 10 times worse, where you lose 30% of your money, 40%, 50%, all the way down. Going through that experience is a lot different on paper than in person. And particularly, it's a lot different if you're a 20-something with no money versus someone who has a family and kids and trying to put food on the table.
So, I would love to be able to say we're all cold robots. And we could do it in a way that's automated and thoughtful. But we're humans. And that's not to say that we're just so dumb as humans; it's rather to say that this is hard. And to have a little kindness with yourself and understand the whole process. You guys have done more, by the way, on this category than anyone on education, particularly with having a written plan. You talk specifically a lot about this, and we poll people often on Twitter, all sorts of questions. We say, "Do you have an actual written investing plan?" It's like 90% don't; I think the other 10% is just kidding themselves. No one does. So, having a plan is of huge importance when you face the uncertain future.
Benz: So, you think that that's sort of a check against just overriding it and going with your gut, if you at least have taken the time to write something down?
Faber: What a nightmare. I can't imagine anything worse or harder. We also poll people. Everyone spends an inordinate amount of time on the buy decision: Should I be investing in gold? What's the Fed doing? Are stocks expensive or cheap? And they spend almost zero time ever thinking about or addressing it ahead of time--the sell decision, for example. What happens an investment goes down? Are you going to wait it out? What's your criteria for moving out of it? What happens if it goes up? What happens if you have an absolute rocket ship that 10xs or 100xs? How are you going to think about that as it becomes 20%, 50%, 80% of your portfolio?
All these things to work through ahead of time, because just reams of academic research show… Here's a great example: Everyone go look in your garage, walk around and say, "My goodness, what is all of this junk?" Would you go out today, if someone just cleaned out your garage, and buy all that stuff again? Are you kidding me? That aquarium from 1980; that Commodore 64 computer that's been sitting there; all this just junk. Of course not, but we have a different emotional attachment to things we own versus things we don't own.
And we always tell people, "Pretend you don't have a portfolio at all. Write down your ideal portfolio. What would it look like, what are the rules compared with what you have today?" And if there's a big difference, there's a problem. You have an emotional attachment to these--we call it mutual fund salad--where I think the average financial advisor that's been in business for 20-plus years owns like, it's hundreds--I think it's 200 mutual funds across their clients--which is totally insane and they're professionals. So, you accumulate a lot of this mental baggage. I think it's great to think about having a clean slate--we call it the zero-budget portfolio. Clean it out, think about what you would start with today. And that gives you freedom to have at least an open mind.
Ptak: You often use the word "fun" in describing your activities in business ventures. That's great, we should all have more fun. But as a practical matter, how do you ensure that your investments strike the right balance between advancing your financial objectives versus providing a diversion or an escape?
Faber: We did an article a few years ago called "The Best Way To Add Yield To Your Portfolio." And we said, "How much time do you spend on your portfolio per week?" And then, "How much money do you make per year? How big is your portfolio?" And we basically demonstrated that it is a massive, massive cost to be wasting time on your portfolio, versus where you could put a dollar amount on the time value of your time. Unless you love doing it; that's one thing. And we say you could add yield to your portfolio by just putting on automatic and doing other things with your life, whether it's spending time with your family, playing golf, working more hours, trying to get a better job, all these extra things. I think investing for the vast majority of your portfolio should be on absolute autopilot. It should be run by a robot. We've written a long series of articles called, should CalPERS be managed by a robot? Should Harvard be managed by a robot? Should almost every institution be managed by a robot? And I think the answer to that unequivocally is almost, yes. And we can get into how they could do that and the research behind it.
That having been said, I love the financial markets. I love being a student of history. It's a constant challenge every day. It's exciting. It's wondrous. So, the fun that I have is sort of like Buffett talking about skipping, whistling to work. I love this career. And I encourage everyone, to the extent you have that choice. There's no bigger blessing than to have a career you love. So the vast majority of your portfolio I think should be automated with all of your inputs ahead of time and put it on autopilot.
However, there are other areas of investing that everyone has their own paintbrush. And a lot of this is based on your own experience. Some people actually love researching micro-cap companies in their own neighborhoods; some people love getting their hands dirty and looking into farmland investments; some people love the Jim Rogers style--traveling around the world visiting all sorts of cool countries. And, for me, a big part of it over the last decade, has been startup investing and getting to see all these amazing startup companies that are looking to change the world. And we can get into that too, as well. But for me, it's all fun. Doesn't mean it's not painful sometimes, but it's been a blast.
Benz: There's a lot to like about that attitude. I do want to delve into your approach to startups later on. But before that, let's shift and talk about your belief system as an investor, the things that underpin the way you approach investing. You're really strong believer in valuation as an input to the investment decisions that you make. And you've written extensively about areas that you believe are overvalued, the U.S. stock market in particular. So how overvalued are U.S. stocks, in your opinion, and what's the basis for you making that assessment?
Faber: Let's go back five decades. And this was before I was born, but there was a massive earthquake/nuclear bomb went off in the asset-management industry. It went by the name of John Bogle, but many others, with the starting of Vanguard, and essentially, the launch of index funds. Now, this is where I depart with the rest of historians and participants, because most people would look back and say is that index fund changed the world. And I would comment, that's not actually true. I think it's what the index fund enabled. And what the index fund enabled was being able to offer investment products at low cost and low fees. And so let's talk about if you were to poll people: What is a market-cap-weighted index? I'm guessing if they were honest, most people would have a hard time describing it, because I've polled a lot of friends and even people that are in the industry. And a lot of people struggle.
They say, "It's the largest stocks in the U.S. stock market, largest companies." And I say "Yes, by what measure?" They say, "By size." And I say, "What does that mean?" They'll say, "By revenue or sales or earnings." I say "No, no, no. Market-cap-weighted index is simply the price of the stock times the shares outstanding." It is the ultimate momentum and trend index. Now, that is not a bad thing. Let's be very clear. Because it guarantees you own "the market." As a stock, it gets to be bigger and bigger. As it goes up, market-cap-weighting, so think about Apple, multi-trillion-dollar companies today. You own more and more of it as the stock goes down--think Enron, or something, eventually goes away, you own less and less. Why does that work historically? Because you are guaranteed to own the winners. And it becomes a fantastic way to invest. But it is a very curious way to invest. If you were to talk to Warren Buffett or anyone else about buying housing or your local pizza parlor, no one would do it based on market-cap weighting. But here we are 50 years later.
The challenge of market-cap-weighting is it has no tether to fundamentals. It often overexposes you to bubbles. And as things get more and more expensive, you own more and more of them. And if you look back over the course of the last 100 years, our favorite metric is the 10-year price/earnings ratio adjusted for inflation--people call it the Shiller CAPE ratio. It doesn't matter, all the valuation metrics always say the same thing. You could use dividend yield, doesn't matter. But if you look back in history, stock markets, on average, trade around 17, on this CAPE ratio, what we call it. Lower inflation times it's allowed to be higher, so 1% to 4% inflations around 22.
But there's been times in history for the U.S. market, for example, has been as low as 5; it's been as high as 44 in the '99 bubble. By the way, it's at 39 today, second-highest it's ever been--we’ll come back to that. So, the problem is, though, is you own more as things go up. Japan, for example, in the 1980s was the biggest bubble we've ever seen. It hit a long-term P/E ratio of almost 100. The Japanese stock market then went nowhere for 30 years. And this wasn't some backwater economy; it was the largest stock market in the world at the time. So if you are an indexer, globally you put most of your money in the most-expensive stock market of all time at the exact peak. It's the exact opposite way you should be investing. And now on the flip side, too, when things get super cheap, when no one wants them, when they are P/E ratio 5, you invest the least.
Now this applies not just to global countries, but also to sectors to industries. There's been lot of great studies by many different academics and practitioners--Research Affiliates is one of my favorites. They show the largest stock in a market-cap-weighted index goes on to underperform that index by about 3 percentage points per year for the next decade; not one or two years, for the next decade. This applies in every sector, it's even worse in some countries. So long-winded answer to your question, the first thing you can do is break that market-cap link; you can invest in any way other than market-cap-weighting. That will give you, hopefully--we prefer value, like you mentioned--a tilt toward things that are cheap, should we think outperform market-cap-weighted indexes by 1 or 2 percentage points per year.
The problem right now in 2021, of the 45 countries around the world, the U.S. is one of the most expensive markets in the world. The U.S. is also the largest market cap just like Japan was in the 80s. The U.S. is up around 39. And the good news is most of the rest of the world is totally reasonable to downright cheap to screaming cheap. I'm happy to talk more about that. That was a long-winded answer to your question. But as you think about construction-- I'm going to tie a bow on this at the very end--going back to Bogle, Vanguard actually manages more active funds than they do passive. Now they have more assets in passive. But this term over 50 years has been totally corrupted. It used to mean one thing and one thing only: market-cap-weighted indexes. But now it means all sorts of things. And so, he himself said before he passed, he said the conflict of interest in the industry is not active versus passive. It's high cost versus low cost. So, you now have a world where you can have active funds that are super cheap, and passive funds that charge 1.5%. So, the whole point on this is focus on low costs. And also preferably use a little common sense and break the market-cap link.
Ptak: We've seen torrents of fund flows to cap-weighted, total-market-cap funds. Are newly arrived investors sitting ducks in your opinion?
Faber: Probably. Let's talk specifically about the U.S. And, again, we've talked a lot about Bogle already, but he's certainly an idol to many, and I put him in that category. But he wrote a paper in the ‘90s where--he wouldn't have called it this, by the way--but he had a very simple formula that talks about how to come up with expectations for stocks over the next decade. I would call it a forecast; he would call it probably expectations. And it's very simple, three inputs: starting dividend yield, earnings or dividends growth, and then change in valuation. Well you know the starting dividend yield, and it's approaching all-time lows currently. If you say let's assume similar earnings growth is the past, well, then the big variable comes--what's the valuation multiple going to do over the next decade? And so, if you input those numbers, you say I'm going to start with a starting dividend yield 1.3%. We'll assume historical earnings growth, so let's call it 5%. So, not bad we're up to 6.3%.
Well, the problem is the historical return is up around 9%, so it's already lower than history. Most investors, in surveys recently--Schroeder's and then others--showed people are expecting 15% returns. So, expectations are way out of whack with reality. But if you then look at valuations and say, over the next 10 years, let's say valuations go back to normal inflationary times of 22. All of a sudden, you have a very big headwind of valuation, multiple compression over the next decade. So instead of that historical 9%, you don't even get to the 6% of just the dividend-earnings growth. You're back down to low single digits. Buffett before he passed away-- by the way, this was before the big run the last few years--he said he expects the stock to do like 4%, and now it's down to 0 to 2%.
However, the huge caveat… This is like playing blackjack or going to the casino--everyone knows the future is a spectrum of all sorts of different possibilities, probably called the metaverse today. So, there's a scenario where inflation ticks up. And, by the way, multiples fall off a cliff; they first go on a slide, then they fall off a cliff, as inflation ticks above 4%. Above 6% is when they fall off a cliff. We’ll probably print 5% later this year. So if that happens, you don't go back down to 22 on the long term P/E ratio, or even 17, you may go down to 10 or 5. And in that case, you're looking at negative stock returns, maybe 5% a year for the next decade. Terrible. But for stocks to even get to historical returns you have to see valuation multiples expand, which at 39, one of the highest ever. And people always lose their mind when you're talking about CAPE ratio. I don't know why.
Every single valuation indicator says the same thing. You cannot find me a valuation indicator that says stocks are cheap. People love to misinterpret the recent Shiller publications where they're compared with bond yields. All that saying is do stocks look good relative to bonds. And in '99, when stocks hit 44, there was a great alternative, bonds were like 4% or 5%. Well, now they're one and change. So, bonds aren't a good choice. You have one of the worst opportunity sets in history for U.S. investors in stocks and bonds, 60/40 portfolio. You're probably looking at a big fat donut, or bagel, whatever your breakfast food is, over the next decade. The good news is there's lots of opportunity elsewhere, just not in market-cap-weighted U.S. stocks and U.S. government bonds.
Benz: Question is U.S. stocks have looked expensive for a while on the measures that you just cited. So have you revisited any of your previous assumptions about how to value stocks, in light of that experience, in light of the fact that we had flashing red signals several years ago, and yet the market has continued to be really strong?
Faber: There's a lot of topics that if you ask me, on the financial markets, I have very strong opinions on; there's some that I don't. And then there's an entire thread I have on Twitter, called "What Do I Believe" that 75% of my professional peers disagree with and it's probably 20 tweets long and growing. So, there's a lot. This is one in particular. A lot of market participants who are very educated, and absolute pros in their field, get this one wrong. And people see a stock market that's expensive, like the U.S. is now. And if it continues going up and getting more expensive--let's say the CAPE ratio goes from 39 to 42 to 45, which is where it was in the late 90s, before we had no returns for a decade. And let's say it keeps going, let's say it goes to 50 or 60--which, by the way, India and China were in 2007 before they had no returns for a decade. People say, "Valuation must not work because things got more expensive." That is exactly how valuation works. That is a feature not a bug.
As things get more expensive, all you're doing is pulling future returns. As you remember, the stock market as a whole is just a claim on all future cash flows. All you're doing is pulling future returns to today and vice versa. If the market goes down 80% tomorrow, all of a sudden it’s the best thing ever that could happen to a 20-year old, 15-year old, 30-year old, because they get to put investments in market at very low valuations. One of my favorite books on investing--it's not an investing book--is Kurt Vonnegut's Galapagos. And it's actually timely because he talks about a global pandemic and he talks about financial markets going haywire. And at the end of it, he says why did all these changes happen, and these economies collapse, and markets crash? And the summary was at the end, he says all that changed was people's opinion of the place.
And so, this sentiment plays an incredible role. One of my favorite sentiment examples, if you go back at the AAII Sentiment Surveys that go back 50 years, they ask people are you bullish, neutral, or bearish on stocks? And people were the most bullish on stocks in December 1999. In the history of the survey, the single highest bullish month, was when the stocks were the most overvalued in history. That's the exact opposite of what you would want to be. And guess when people were most bearish? You could not make this up, you could not write a worse sitcom about this: March of 2009, the best buying opportunity in our recent lifetime. And, so valuation, it's like this old psychotic Mr. Market that shows up every day. Nobody would look at their neighborhood and see if a house quadruples in the last year and say, "Valuation must not work. Let's go buy that house now, when nothing has changed." And and so it's a very odd example.
And historically, a much better approach is to be value-conscious. If you use value across countries, within sectors, we have over 100-year history showing that value works great, absolutely fantastic. And the best thing is it helps you avoid these crazy bubbles. And it gives you an anchor from which to base a lot of your decisions and at least have some perspective. We did a poll on Twitter. And I said, "Would you continue to own stocks (because everyone own stocks)?" I said, "Do you own stocks?" It's like 100%. "Would you continue to own stocks if they hit a valuation P/E of 50?" And half the people said, "Yes." So that's higher than it's ever been in history in the U.S. And I said, "Would you continue to own them at 100, 100 times earnings?" And a third said, "Yes." So higher than Japan, in the entire history of our database of countries, the biggest bubble we've ever seen. And that to me, goes to show that people are not optimizing on common sense when they're allocating to equities.
And that's a problem. Now, it's not a problem if you're global. But, as we talked about many times, U.S. investors put 80% of their money in U.S. stocks, which is a massive home country bias, because it used to be around half--now it's about 60% of the world is U.S. has a percentage of market-cap-weighting.
Ptak: What do you make of the fact that with respect to fund flows, at least here in the U.S., we've actually seen investors net selling things like U.S. stock funds, despite the fact that multiples are higher and the litany of facts that you laid out. And, actually, they've been net buyers of international stock funds, which is the opposite of what I think we've been accustomed to seeing. So, when you look at that data, how do you reconcile it with the rest of the picture that you're seeing and describing for us?
Faber: It's great. It means they've been listening to the Meb Faber Show and reading some of my books, I guess. But, seriously, if you look at the U.S., 39 P/E ratio foreign-developed is down around 22, the average country, emerging-markets are down around 15. And then the cheapest bucket, the detritus at the bottom of the ocean, is down around 12. And the challenge, and you guys know this more than anyone, is every investment has its day in the sun and day in the shade. And there's times, and problem with most people is these regimes last a lot longer than they expect. So, we're not talking Robinhood time frames of minutes and hours and days and quarters or even years, but decades. If you look at 2000 decade, the darlings of that decade were emerging markets, were commodities, or real estate, small-cap value. And then what has it been the last decade? It has been nothing but the U.S., baby--all U.S. stocks, market-cap-weighted--which has led us to write an article called "This Is The Biggest Valuation Spread We've Seen in 40 Years"--U.S. versus the rest of the world.
And the difference is if you look over the last 40 years, people love to say, "No, no, Meb, you don't understand, you can't use CAPE ratio for all these reasons; you can't use valuation. The U.S. is special." And I say, "I agree, it is special." They say it deserves a premium. And I said, "What do you think that premium should be?" And they come up with the number and I say, "Over the last 40 years, the premium of U.S. stocks versus foreign stocks is zero." It's technically not zero, it's like 0.5 or something. On average, they've had a valuation of around 22, for the last 40 years. The difference was, again, 40 years ago, the U.S. was cheap, and the rest of the world was expensive, in particular, Japan. So, there's always crisis going on somewhere. And if you look at the P in the P/E ratio, that's what drives it. There's some country usually down 40%, 60%, 80%, 90%.
I like to joke--I was in Bogota about five years ago giving a speech and was very unpopular, because I told all the locals that I love your food, love this country, beautiful. Your stock market is super expensive. It was in the 30s at the time, might even been 40. And I said historically, that's not been a warm, fuzzy place to be. And they've had a horrific return since. But everyone pulled me aside and said, "Meb, you don't understand," and listed all the reasons why the market would continue to go up. And so, having this valuation perspective, I love it. Nothing makes me happier than to hear people say they're allocating to foreign; my experience is most don't. So, the starting point is, if you look at just stocks, we would say roughly is half U.S. and half foreign, emerging markets down around probably 13%. The average person to allocate emerging markets is 3% out of the total. And getting away from what we call home-country bias makes a lot of sense. I'm a huge Broncos fan.
Every country all around the world allocates way more to their own country than they should. And it's particularly problematic in two scenarios, one where the country is tiny. So, if you're 3% of the world-market cap, like Canada or something, and you're putting in 70% in Canadian stocks, for a Canadian that's like junior miners and cannabis, that's their barbell. It's a huge overweight, that's a huge active bet. Maybe it'll work out, but you go ask all these countries around the world over the last decade, and in likelihood, it won't. So we did a post on our blog called the "Case for Global Investing," and if you look back in history, you go back to 1900. The U.S. has stomped everything this decade; pat yourself on the back, you've been overweight, glass of champagne, toast your friends. But then that's actually pretty rare. It's happened, I believe in the ‘90s. And then before that, you got to go back to, I think 1910 decade, where the U.S. outperformed the broad average.
So, people love to extrapolate the recent past. But historically speaking, the world is your oyster and looking beyond your borders, and any given year, 75% of the best top-100 stocks’ performance globally is outside the U.S. So, as a quant, we would say that you want a lot of breadth. You want more choices than less. And there's a lot of gems outside of our borders.
Benz: I wanted to talk about trend-following. You've long been a proponent of trend-following. When it comes to investing, you wrote an influential book called A Quantitative Approach to Tactical Asset Allocation. That might seem a bit contradictory given that we've just had a discussion about valuation. And I think on its surface trend-following seems a little bit contrary to valuation sensitivity. So, for our listeners who aren't familiar with trend-following, perhaps you can give just a quick overview of what trend-following is, and why you think it has merit as an investment approach.
Faber: As a historian and quant I like to look back into history and say what has worked, what have been approaches that are thoughtful, that are likely to be repeatable in the future, that aren't just data-mined, based on optimizing the data set. And there's two big ones. And, by the way, as much as I've been dunking on market-cap-weighting, it's totally fine if you do a global market-cap-weighting diversification. It's not the best place, but it's fine. Particularly with low cost--huge caveat. And to be very clear, market-cap-weighting is a trend-following strategy. You are doing nothing more than owning something based on price, and you own more as it goes up and less as it goes down. But that's semantics. You go back 100 years--two of the biggest pillars on which we manage funds, we have a dozen now, ETFs. One is value, to go back to the time of Ben Graham, that's well understood by most, particularly in this community. The other is trend-following that goes back to the time of Charles Dow, writing The Wall Street Journal talking about Dow Theory.
Fast forward 100 years, both have been extremely successful. I think people naturally gravitate toward value because it makes sense--it's a little more tangible, they can apply it to their home, or buying a car, or local business. Trend-following is a little more esoteric, and there's a lot of misconceptions when it comes to trend-following. When we wrote this paper, we talked about a very simple strategy, which was the goal in investing is you want the upside, ideally, and you don't want to sit around for the really big haymaker "take you to the woodshed, you're going to lose all your money outside," because the worst thing that can happen to an investor, or speculator or a gambler, or anyone who's placing bets, is you no longer have a betting stack. You no longer have any more chips. You're broke, you can't play.
So, avoiding the huge losses and the problem with compounding--the eighth wonder of the world--is that it's also true on the downside. So you lose 10%, you need 12% to get back to even; but the more it goes down, there's a bigger kink, you lose 50%, you need 100% to get back to even; you lose 75%--which has happened essentially in every market around the world at some point--you're going to need 300% to get back to even. So, avoiding these big losses. Trend-following, it doesn't matter the metric you use, just like it doesn't matter the metric used in valuation, most of them should do the same thing. Let's call it the 200-day moving average, one of the most famous in history. You want to be a long market when it's above, you want to be out when it's below. We actually wrote a paper during the pandemic that was unread because there was a pandemic, but it was called, "Is Investing at All-Time Highs a Good Idea? No, It's a Great Idea." And we showed a very similar system--and, again, these have been around for 50, 100 years in various books and literature--that would buy markets at all-time highs and then sell them after they declined. I forget 5%, 10% percent or 12-month look-back.
And the takeaway is you end up with better performance. It's usually similar. It's not a outperformance-type of strategy on a simple trend-following metric. But you avoid these huge downdrafts. So, one of the hardest parts for investors is sitting there as a market goes down, and we had two 50%-ers in the last 20 years. But we've had over 80%-er during the Great Depression and plenty of countries around the world have had 80%-90%-ers losses. That's really hard. That is extremely hard to sit through losing that much money. Think about investors, put a number in your head, close your eyes, that's your portfolio, now subtract 80%. How much damage would that do to your psyche, your relationships, your economic situation, on and on. So, trend-following tries to say, "As the market is declining, let's get out and move to the safety of cash."
As we talked about the U.S. stock market, there's nine indicators that are flashing yellow. So, going back earlier to valuations, it's not flashing red in my mind, it's flashing yellow, but it's pretty bright yellow. And the final boss, like the final indicator that we say needs to trip, is the trend and the trend has been up for the better part of the last decade. We've had a few jiggles over the last few years, but largely trend has been up. So all trend is trying to do is save your hide. Now it's equally hard--as is buy and hold investing, both fantastic investing strategies--both are hard for different reasons, happy to get into that. But trend-following has a long and storied history of being a great investing strategy.
Ptak: So maybe you could talk briefly about how you incorporate trend-following into the professional money management that you do principally through your ETFs. As you've already mentioned, it's not all of what you do; it's part of what you do. And if somebody were to come to you and say, "I'm interested in trend-following, you've convinced me. How should I incorporate it into what I do?" How would you advise them?
Faber: Let's dig in. And I want to make one comment before I get started. And that is much as I've been ranting and pulling my hair out about market-cap-weighted U.S. stocks, you know, one of our largest funds is a U.S. stock fund. I will say U.S. stocks are an attractive asset class if you tilt toward value, by the way, small cap and value. This is actually one of the biggest opportunities in history for value stocks in avoiding the market-cap-weighting. We say the chart of the year for 2021, as you go back to 1920 and look at value strategies within the U.S, the worst year for value ever was 1999. No surprise, but the best year for value ever was 2000. Until 2020. 2020 was actually worse for value strategies, cheap versus expensive, than 1999. 2021 is playing along the same theme as 2000. So, value stocks are having a monster year, but it is just baseball analogy--I don't even know if it's inning one or two, you may just still be on the on-deck circle. This could last for a decade. So, I just don't want to characterize people saying "Meb, you hate U.S. stocks." No, I hate market-cap-weighting, love value strategies within the U.S. I think they outperform for a decade. OK, you may have to splice that in, by the way.
Let's talk about trend versus buy and hold. The global market portfolio--let's say you went out and bought the world, and say "I want to buy every public asset in the world and model my portfolio after that." It's roughly half stocks, half bonds, and then within that it's half U.S. and half foreign. That's been a fantastic portfolio over time, despite the fact it is market-cap-weighted, it gives you a broad diversification across everything. That buy-and-hold portfolio, if implemented with low fees--and we could come back to that if you guys want--has been an outstanding way to invest.
The problem with buy and hold, it is highly correlated to what's going on in the world, meaning GDP. And so, when the bad times happen--think last year, think the global financial crisis--your portfolio declines along with the bad things happening. So, you're like double or triple leverage what's going on in the world, if that makes sense. And ideally, it's hard to watch your portfolio go down at the same time that the economy is going down, unemployment is spiking--it's all happening at once. Ideally, the two would sort of zig and zag. So, you would have more money when times are bad versus when the economy is tanking. And buy and hold is hard, because people have a really hard time sitting on their hands. The old Bogle quote, "Don't just do something, stand there." It's hard for a lot of people, particularly as the drawdowns come. Not everybody; some people have steely resolve, but in general it's hard.
On the flip side, trend-following usually works about the same as buy and hold. I think it would outperform over time, particularly lower volatility, lower drawdowns. Trend-following is also hard as a portfolio, and we have funds on both ends of the spectrum. So, we have an asset-allocation fund, one of the cheapest in the world that does just a buy and hold the global market portfolio with tilt. So, we don't do market-cap-weighting as much as I've been talking about it. It tilts toward value, tilts toward momentum. On the opposite side, we have a pure trend-following fund. And these two are like cousins that don't really like each other. So, they zig and zag at various periods. Trend-following is also hard because if you're doing it on your own, it's even harder, because you have a lot of losing trades. It's like a death by 1,000 cuts. You get kind of chopped up on these whipsaws sideways, the market goes up and then it reverses down and you get out. It goes back up, you buy it back, and it goes down here and you’re out. So, you have this sort of choppy costs and transactions. But it usually gets the really big moves up right, and it stays away from the really long moves down.
Trend-following historically does great during times of crisis, because it'll either be exiting to the safety of cash and bonds, or to the extent the trend-following strategy does it, it'll be short. For me personally, and for everyone, this is a very specialized decision. We do what we call the Trinity portfolio. We put half in global buy and hold with all these tilts. And then half in trend-following. With the hope being, 2020 is a perfect example, for the first half of the year, I said, "Thank goodness we have trend-following because it looks like the world is going to fall into the ocean. It's going to be like the zombie apocalypse." And then for the second half of the year, I said "My goodness, thank the world for buy and hold, because the world has rebounded. And things are going to all-time highs."
So, you have this diversification that you don't have to think in binary terms. All in, all out on one strategy, while realizing they're both hard, and historically, it's been a great way to approach it. It's not for everyone. But it's an area that I put almost all my public assets into this one specific strategy and fund. As you guys know, the vast majority of public fund managers don't invest in their own funds at all. We think it's important to have skin in the game. But for me, a one-fund portfolio is totally fine for public assets that includes all the strategies and ideas we've talked about thus far today.
Benz: Well, listening to you, Meb, I can't help but wonder, do you think that investors are underrating active management at this point, assuming it's a cheap active fund? Are a lot of the factors that have worked against active managers potentially coiled to benefit them going forward?
Faber: I think the traditional labels of active and passive have lost all meaning. As an example, we have one of the cheapest asset-allocation funds in the world, but it's active. And there are index funds out there that charge 1%, 1.5%. You could develop an index today that says, does the CEO eat cheeseburgers, hamburgers, or veggie burgers? And divide up the stock universe by that and charge 2% a year. And that's technically a passive index fund. Is it totally insane? Why would anyone invest that way? But it's an index fund. Going back to the earlier part of conversation, I think it's about cost. I think it's about common sense. The ETF wrapper has been an absolute revolution in investing. The most boring thing to talk about is taxes and fees.
But the average ETF versus the average mutual fund in the equity world, you have about a 70-basis-point fee advantage for the ETF structure. Mutual funds have so much legacy costs and conflicts of interest. On top of that you have about a 70-basis-point tax advantage. So just from the structure, you're looking at over 1% in structural benefits. It's a shame that it's that way, but that's not my problem. IRS and then the government could change that with a stroke of a pen, but they won't. So, we talk a lot about how you need to pay a lot of attention to taxes and fees. We've actually said this quite a bit. On the buy and hold side, by the way, your asset allocation really doesn't matter. And this is another one that no one agrees with me on.
We wrote a book that's free online, it's called Global Asset Allocation. Where we went back to the 1970s, gave you guys a crystal ball. We did a horse race for all the famous asset-allocation strategies, permanent portfolio, 60/40, endowment style, risk parity, on and on. And we said we're going to test how all these worked over the last 50 years. And the amazing takeaway is, they all did a great job. They zigged and zagged different times, but they basically all ended up at the same place. However, if you went back to 1970, and said, "I'm going to let you pick out the single best-performing portfolio out of this book. How much would you pay me for that, Genie?" And the answer is, I don't know--Pimco, Fidelity would probably pay $10 billion for perfect foresight into what the best portfolio was. I said, however, "I'm a mischievous Genie, and I'm going to say you have to implement this with the average mutual fund fee today." So, let's call it around 1%. I know that's not dollar-weighted; that's the average fee, though. And back then forget about 1%. Let's call it 2%.
We'll be a mischievous, but nice Genie--1% fee. That takes the best-performing strategy over the last 50 years, which was El-Erian's endowment-style portfolio, which is growth-oriented, equity-oriented, and makes it almost as bad as the worst. So just layering in average fees of today renders the entire asset-allocation decision meaningless. All this time that people spend on how much should I have in stocks and bonds and real estate and commodities, and so on--meaningless for the buy and hold investor. Even worse, and I love you guys, but if you say I'm going to add on 1% for financial advisor, and I think financial advisors bring a ton of value on lots of areas--estate planning, taxes, compliance, behavioral coaching--but let's say you're just doing buy and hold investing. So, you're up to 2% now.
It takes the best-performing perfect-foresight portfolio and makes it far worse than the worst portfolio in this entire book over a dozen strategies. The point being, if you're going to do buy and hold investing, it's like baking. If you're making cookies, it doesn't matter exactly how many chocolate chips you have butter, sugar, and so on, as long as you have some of all the main ingredients. The top-three global stocks, global bonds, global real assets, like real estate and commodities--you got to have some of each because each environment's different. The real assets helped in the ‘70s, stocks helped in the ‘80s and ‘90s, and so on.
But what really matters is fees and taxes, and then just putting that sucker on autopilot. Trend-following and other additions to that portfolio can help, but just talking specifically about the way that 90% of the world invests, that takeaway is extremely profound; no one else thinks it is. I think it's not a unique insight, but I think it is a critical insight and the good news is you guys just put out your fees study. Most of the world seems to be moving that direction--toward low cost, low fees, which is great. It's never been a better time to be an individual or institutional investor than in 2021.
Ptak: Another dimension, I suppose, in addition to some of the factors that you just cited is, where you're going to use your own discretion to make investment decisions and where you'll rely on maybe structures or rules. And so, my question is, how intentional are you about the mix of investment decisions you're making across your full portfolio, which spans not just public investments, but also private investments, which we haven't talked about. Some of those decisions seem to be very discretionary. I think of your angel investments and a bit idiosyncratic, but then there are others, like you've been talking about, your public investments are much more structured and rules-based. So does the current mix, does that reflect a conscious choice you made about how to budget and target your own discretionary decisions? And do you think that that's something that investors more broadly, that they themselves should be more conscious and purposeful about?
Faber: It's an important question. There's two parts to it. The first is, I think it's important to be kind with yourself and not extremely judgmental about the investing process. At the same time, also important to be open-minded. So, we all make a ton of mistakes. We say to be a good investor, you have to be a good loser. Because the average market, over time, there's only two states: you can be at an all-time high or you going to be in a drawdown; there is no other in between. And most markets spend the vast majority of time in some form of drawdown. And that's OK. You have to be a good loser; you have to be used to all the noise and just negativity that involves public-market investing.
That having been said, it's important to be open-minded, so to realize when things change. Also to be open-minded and realize the challenge of this time is different seduction. But a good example--go back to 1980s, there was a very real, specific structural change in markets that people have not accounted for still to this day. And that was companies started buying back more stock. They had safe harbor from getting trouble for doing it. So, they started buying back stock starting in the ‘80s. And now starting in the late ‘90s, buybacks account for more of the ways that companies distribute cash than dividends do. Now there's a ton of misinformation when it comes to buybacks. We could do an entire podcast on that topic alone. So much that we did a post called "FAQ for lawmakers," gurus, investors, and so on, about buybacks and dividends.
Buybacks are the exact same thing as dividends, as long as stocks trading at intrinsic value. That's finance 101, you can't argue that fact. If you do, I can't help you. I can help you--call me, email me, we'll talk about it. But that is a fact. The beauty of buybacks is it gives investors discretion on timing; they're more tax-efficient. Look at Warren Buffett. He says the only time his company has paid a dividend was he was in the bathroom back in the 1960s or something. And he's buying back a ton of Berkshire stock today. So, he gets it. He says there's nothing better a company can do when a stock is trading below intrinsic value--and that's the key phrase--than buy back their own shares.
You have to avoid companies that are consistently issuing shares, you have to avoid companies that are just buying back to mop up the share issuance. But, in general, you have to look at cash distributions holistically. That's totally changed. That wasn't the case 50 years ago. And so that was a very real structural shift, that how many hundreds of investing strategies are still based on dividends. And it's totally insane to only use one tiny bit of information in a world where there has been a real shift. And you could show historically speaking with both simulated returns, as well as real-time returns--we manage a whole suite of these funds for almost a decade now. We call it shareholder yield. So, combining both, also tilting toward value, is a better approach than dividend investing. But people, whether it's because their income depends on it, or they just have blinders on, haven't shifted their focus.
And, so, it's good to be open-minded and say, "I'm going to absorb information, add it to my investing process as things change." Another good example, now that we have ETFs--far superior vehicle than mutual funds, but ETFs didn't exist in the ‘80s--incorporate this new information. That doesn't mean you're waking up tomorrow and say, "I got to sell everything and buy gold or an ether rock." It just means be thoughtful about it. Most of these decisions I used to liken it to Peyton Manning playing for the Broncos--who knows who the quarterback is going to be now--but he comes to the line of scrimmage. He knows exactly what he's going to do. The defense shifts, he's got his three audibles. It's not like he shows up and says, "Let's just wing it." That's the worst thing you can do.
So, having an investing approach, writing it down, being thoughtful about it, but also saying, "I'm not going to be just set in stone. As new information comes online, I will incorporate it if it's additive and thoughtful." But you also try to set up that criteria, too. And then for people that want to do a little discretionary trading or playing around, it's sort of an all-time nightmare for me. It sounds like such a drain and attack on your mental well-being and health. But putting a little bit over there, 5%, 10%, I think that's totally fine. I think if that keeps you behaving in the rest of your portfolio, that's A-OK with me.
Benz: It seems like you're someone who likes to tinker with things, play around with new technologies or applications to solving a problem or filling a gap. In the past, for example, you've said that there needs to be a podcast-episode-rating app. What's another problem that you think is practically crying out for a solution? Maybe you can give an example from your investment portfolio, investments that you've made, as well as in the real world.
Faber: Let me tell investors about a really awesome insight that when we asked Twitter, I think 98% said they've never heard of. So, there's an incredibly impactful piece of legislation that passed during Obama's administration that's been pretty quiet in the investing community. It's called QSBS. I'm going to probably murder it, but I think its Qualified Small-Business Stock. Basically, with this QSBS legislation, if you invest in a startup company, and your gains on that investment, if you hold it five years, either 10x the investment or $10 million, whichever is greater is tax-free, and let that sit in for a second. Taxes are a huge cost to the investor over time. And if I could tell you, you can invest tax-free, my God, amazing. So, people do that; they should obviously max out their 401(k)s, their retirements, and so on.
And we have a whole post on our blog about trying to solve the wage and income gap and wealth gap in the U.S. with universal retirement ideas. That's probably a two-hour podcast. But they passed this legislation. And so, you've seen this boom in startup investing, you're seeing it's either crescendo now, or hopefully, it's just the early days. But the concept being is that you can now invest in these early stage companies and not have to pay capital gains on it. So, I started doing this in 2014 and have invested in over 250 companies. And let's take a step back. What does it mean to be an investor, if you were to ask Buffett, or anyone really? You want to be investing in great businesses run by killer founders that are solving the world's hardest problems, and that eventually will generate lots and boatloads and bags full of cash, that they'll then distribute to their investors at some point. That's a great business. And so, for Buffett, maybe that's Coke or Apple--they have this bigger scale.
But very much the scenario where--and this is true in public-market investing and this is also true in private-market investing--all of the returns, and this can be true for the S&P, it's true for the startups, are determined by about 10% of the stocks. So, in public markets, it's Amazon, Apple, Walmart, Home Depot, on and on. Same thing on private investing, you invest in 50 or 100 companies. We wrote an article about this called "Journey to 100x." Of the 100 companies, maybe five will determine all of your return, because they went full rocket ship from $50 million to a unicorn of $1 billion, $5 billion, $10 billion, like an Uber is a great example.
And so putting together a portfolio of these companies, there's a lot of resources to do this today on AngelList, and a lot of crowdfunding boutiques. The accredited rules are moving in the right direction, they've come down. Hopefully it becomes like a drivers license test and everyone can do this. But you can put together a portfolio of these companies and there's a total barbell scenario--public markets, there's so much negativity and stress. Private markets every day, you're reviewing companies, these startups that are trying to change the world. And it's incredibly optimistic. And I've actually been able to incorporate a lot of these ideas into my personal life, into my work life, and it's also been a lot of fun.
So, an example: As we talk about ideas, and this is one for a company and one for personal that people will love--but things like the world's first commercial space station. Amazing. I was an aerospace guy as a kid, my dad was in aerospace, my brother, I went to see my first rocket launch recently. How cool is that? There's a company called MainStreet. If you're a CEO, or CFO, or you work for a company with say, less than 500 employees, they will free audit your financials, and then apply for all of the tax breaks you could get. It's in the hundreds now, but there was a couple in the beginning, and they say the average company saves $70,000 a year. How cool is that, right?
There's nothing people love more than getting free money, particularly when it's from the government. And as you guys probably have seen me on Twitter over the years, there's the personal version, which is a website called Unclaimed.org, where you can type your name or your family's name. And it'll show if you have unclaimed assets somewhere in all the various states you lived in. There's billions sitting in the state coffers. And we've helped our followers find millions over the year, this is totally free by the way, and many followers have found $50,000, $100,000, $200,000 just sitting there that they didn't know about from something that got left behind from a family member, a trust, cable bills, some of that Disney stock that's sitting there. Now if you’re a financial advisor, you can search your clients as well. Talk about having a client for life--you find them some money that the government owes them they'll be happy as can be.
So, anyway, it's a lot of fun. It has massive tax benefits, and one of the biggest of all--and this is something that I've long considered, and most of the market considers to be a negative-- and that's illiquidity. It's actually, I think, a benefit. If you go back to the Coffee Can portfolio of Robert Kirby in the ‘80s, he talked about buying these investments, socking them away, forgetting about them. And that's where you get these compounders that go 10x, 100x, which usually takes a decade. We often tell investors when they ask us about our strategies, how long should you give it, and I used to, say 10 years, and they would laugh, and now I say 20. And they usually just walk away at this point. But that's how long you need for some of these companies to compound and create real generational wealth.
The beauty of the private investments, you can't sell them, you can only sell them if they have a liquidity event, they merge, they get bought, they go public. So, you have the ability to just sock them away, invest, which is a lot harder in public markets, because you can pull up your brokerage account online every day and see where the stock is trading. With the private it really goes back to a lot of the purposes of investing in the first place, buying great businesses, letting them compound, not messing with them, and above all, not having to pay taxes.
Ptak: For a closing question, I wanted to return to your excellent podcast and ask you, who do you think has been your most memorable guest, and of all the episodes you've recorded, which is the one you'd be the first to relisten to if you had to pick just one?
Faber: That's an impossible question. I love all my children. We actually did one this week with Nathan Myhrvold, who was so much fun. He has almost a fictitious resume. He graduated college at 14, did his Ph.D. under Stephen Hawking on astrophysics, was the CTO of Microsoft for a long time. Eventually retired to become a chef, went to culinary institute. In the meantime, has found more T-rex dinosaur bones than anyone in the world. He just finished writing a 1,700-page book about cooking pizza. I think he has about 1,000 patents and started a nuclear reactor company, which is going to start construction soon in Wyoming. And that's just the ones I can remember. This is this week. And so he’s the world's most interesting man.
But if I had to say one historically, I would probably say arguably the best-performing hedge fund in history outside of RenTec with Jim Simons was old-school Ed Thorp's Princeton Newport Partners, which I don't think ever had a down quarter in its entire existence. And for those younger listeners who don't know who Ed Thorp is, Ed was the person that first figured out how to beat the casino at blackjack, published the book, Beat the Dealer. He eventually published another book called Beat the Market, which was about arbitrage and trading all sorts of situations. And, so, he's got a lot of fun stories. I love the old-school investors that have been around for a while and have seen all sorts of different markets. Ed had a period where he experimented with trend-following as well. But that's the first one that comes to mind. It's an old one, and it was a few years ago, but certainly a great chat.
Ptak: Well, Meb this has been a fascinating conversation. Thanks so much for spending time with us and sharing your insights. We've really enjoyed it.
Faber: You all, it was a blast. Keep up the great work and let's do it again sometime.
Benz: Sounds good. Thanks, Meb.
Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
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Ptak: And @Syouth1, which is S-Y-O-U-T-H and the number 1.
Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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