Rob Arnott
Investing: The Difference Between Growth and Value (January 11, 2022)
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Value has underperformed growth over the last 12 years by most measure of all time.
Why has value underperformed so much?
- Fed accomodation
- Narrative - marketplace embraces the notion that tech is the new nirvana and they’ll dominate the world
Value relative to growth has gotten cheaper and cheaper by a wider margin than it’s underperformance.
Book value is a terrible measure of the resources of a company in a services economy.
They use a blend of metrics:
- price to book adjusted for intangibles
- price to sales adjusted for debt / equity
- price to cash flow
- price to dividends + buybacks
Value stocks could return 5% or more over the market: Rob Arnott Research Affiliates founder (September 30, 2021)
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Value stocks could return 5%+ over the market over the next 10 years.
Value to growth ratio over time:
- 2007: Value was 1/4
- August 2020: 1/13
- Now: 1/11 (still really cheap)
Could you imagine if the ratio went back to 1/4.
Price to book is the classic academic approach for defining value stocks, but that’s very flawed given today’s current economy.
Services, IP, brand, etc are assets of a company that aren’t reflected in the book value.
Valutaion rations work a lot better when book is adjusted for IP.
Value has had some recent outperformance.
Cisco was the most value company in the world for a period of time in 2000. It has grown sales as 12% a year, its profits at 13% a year, and yet the share price is still below where it was in 2000.
The relationship with interest rates and the growth / value cycle is weak.
[i3] Podcast Episode 48: Research Affiliate’s Rob Arnott (September 9, 2021)
History doesn’t repeat, but it sure rhymes.
Arnott doesn’t think COVID will have a long term impact on the way markets and the economy function. He doesn’t see this as a step towards a future that’s unrecognizable.
We have more money chasing fewer goods and services (because people aren’t producing), which causes inflation.
Falling interest rates are good for growth, rising rates are good for value.
Book value is a terrible measure of value. It misses a huge set of assets like brand, intangibles, team, etc.
Price / book is a weak measure of the valuation of a stock.
Fundamental index relies on:
- sales to price
- cash flow to price
- dividends to price
- book to price
Blend of these 4 defines fundamental index weight vs cap weight. This introduces a value tilt towards companies trading at deep discounts.
Fundamental indexing works way better than ordinary value indexes.
Book value only accounts for around 40% of the total assets of a company.
The rules imposed on a publicly traded stock are more onerous than ever before. The companies that do go public are past their early invest growth years.
Multifactor investing is built on factors that worked historically. Arnott isn’t sure they’ll work in the future or that they have a structural reason to work.
He likes value because it has a behavioral underpinning: things that are uncomfortable to buy ought to have a risk premium.
He’s not a believer in the momentum factor and says it hasn’t worked since 1999. It’s been working for a few years and then crashing. It had great alpha in the 20th century and no alpha in the 21st century.
Value is the cheap factor right now. He likes the vanilla fundamental index right now.
Arnott expects several bouts of “peak fear” in the coming weeks and months.
Emerging markets, UK, and Australia are super cheap. Australia is yielding 5%.
Arnott things emerging market value are great buys right now.
The Fed put rescues the stock market. It doesn’t rescue the economy.
US stocks won’t even beat inflation over next 10 years
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Yellen is trying to rally folks around the Biden infrastructure bill.
The notion that America’s greatness in the world economy hinges on government spending is patently absurd.
Here’s why Arnott thinks America has been a world leader economically:
- self-reliance
- entrepreneurialism
- invention & innovation
Almost none of this comes from the government sector.
The likelihood of the government investing money better than entrepreneurs is slim to none.
Fiscal stimulus actually stimulates corporate profits.
Owners equivalent rent is the metric used to compute CPI. Owners equivalent rent is how much your home would rent if you put it on the market today. It’s a lagging indicator because it’s based on polls.
Housing has soared 17% in the last 12 months and owners equivalent rent is only up 2.6%. Owners equivalent rent will be playing catch up the next few years.
We’ve had a robust recovery since the summer of 2020 and we don’t need the Fed creating free money. Free money has other consequences:
- it doesn’t go to everyone, it goes to the highest rated corporations
- interest rates are a speed bump for excessive spending for individuals and corporations. Corporations will start empire building. This props up zombie companies and encourages bad investments.
US equities are very overvalued.
TINA - there is no alternative.
We’re halfway through the process of getting the baby boomers retired. Tens of millions are underprepared / underfunded for retirement. They’re worried about Social Security falling apart. They’re putting money in the market - valuation indifferent buyers.
In 15 years, all the baby boomers will be retired, and they’ll be valuation indifferent sellers. The will have to sell to buy goods and services.
Arnott is pessimistic on US stocks on a 15 year basis.
Top markets:
- emerging markets bonds - yield are similar to US junk bonds, but much lower risk of default
- emerging market stocks - priced 60% cheaper than the US. In 2008 it was priced 40% above the US.
- emerging market value stocks - really cheap, trading at less than 10x earnings.
Arnott thinks the emerging markets deep value are incredible.
Yellen is urging for a massive ramp up in government spending when we already have a fast growing economy.
Emerging markets don’t have the ability to engage in massive stimulus funded by massive borrowing of money they don’t have. They also can’t engage in lots of money printing. They’re constrained to not make our mistakes.
He’s invested in the Freedom Fund: FRDM. They invest in the 10 most free emerging market economies (least government control / most respect for human liberty). 10 largest stocks in each country, equally weighting the 10 stocks.
He’s also allocated to Pimco’s RAE Emerging Markets Fund (PEIFX).
His biggest allocation is Pimco all asset. This is a worldwide asset allocation away from US stocks & bonds.
They wrote a paper that shows unintended consequences of the COVID panic. Suicides, homicides, accidents, and overdoses (unnatural deaths) are up about 70,000 above the normal run rate.
600,000 people died with COVID, most of whom were in the last 1-2 years of their life.
The unnatural deaths were spread across the life spectrum. The years of life analysis is more robust than the number of death figures.
In 5-10 years, COVID will just be a bad memory. The economy has shown great resilience.
Arnott has shown it’s better to buy stocks that are deleted from indices instead of stocks that are added to indices.
Arnott prefers buying assets that are unloved and out of favor.
Value has underperformed for 13.5 years.
Value has underperformed if you use price / book to select value stocks (which is a terrible measure). The spread between growth:value went from 4:1 (in 2007) to 13:1 (summer 2020).
Value snapback has been nice, but only one tenth of the way back to historic norms.
Value is the cheapest it’s ever been to growth stocks. Value has underperformed because multiples, not because the underlying fundamentals have gotten worse.
Value could massively outperform growth in the coming 5 years if multiples mean revert.
Inflation, bubbles, and the future of value investing (June 24, 2021)
Money managers need to get lucky when they first start out cause they need a good first couple of years.
Arnott is a libertarian. He prefers limited government to big government.
Fiscal stimulus makes its way into the financial markets. Send people money and what they don’t spend will end up going into the capital markets.
Fiscal stimulus causes asset bubbles. Fed governors routinely dismiss this argument.
Fiscal stimulus causes asset bubbles thereby increasing income inequality because the rich are the ones with the assets.
Fiscal stimulus doesn’t stimulate the economy. It doesn’t boost the production of goods and services.
Fiscal stimulus doesn’t stimulate the macro economy.
He doesn’t see this Fed or this government as being eager to shut off the spigot unless they are forced to.
Arnott could imaging fairly severe inflation being greeted with a Fed that keeps rates at zero.
The methodology that the Asset Interactive tool uses has been backtested and they’ve found it to be pretty accurate on a +/- 2% with historical data.
Here are some expected returns for the next 10 years:
- US equities: 2%
- Emerging markets: 8%
- RAFI emerging markets: 13%
RAFI is 99% sure of beating US equities.
He has well over half his liquid net worth in emerging markets fundamental index.
He has a relatively undiversified portfolio at the moment.
Emerging markets have their own version of FANG stocks - they’re called the BAT stocks. Baidu, Alibaba, Tencent.
RAFI is more effective at capturing value in emerging markets than a cap weighted value strategy.
Definition of a bubble:
- What assumptions do you need to make about future growth to justify the current price? If the assumptions are extravagant and implausible, then you might have a bubble
- does the marginal buyer care about valuations
Current examples:
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Apple’s valuation is justifiable with aggressive assumptions. There are Apple buyers that believe in the aggressive assumptions and that’s why they’re buying. Apple doesn’t meet the bubble definition.
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Tesla’s price can only be justified by implausible assumptions. Tesla’s investors aren’t using valuation models. So Tesla meets the definition of a bubble.
Bubbles can last longer and go farther than anyone could possibly imagine.
Anti-bubbles are opposite examples where you need to use implausibly bleak assumptions to not make money. Great examples are Russian and Chinese state-owned enterprises.
Cap weighting overweights the overpriced stock and underweights the cheap stocks.
Active managers get the market returns in aggregate - some win and other lose.
Arnott said every active manager should be asked this question: “If you’re so smart, then who is the loser on the other side of your trades and why are they willing be be stupid”. You don’t know your alpha engine if you don’t know the answer to this.
RAFI contra trades against the market’s biggest bets. The people on the other side of the trade are momentum following trend followers who like to load up on the most expensive, beloved companies. Arnott is confident that they’ll lose in the long run.
They wrote a paper called Reports of Value’s Death Have Been Greatly Exaggerated.
Value has underperformed by getting cheaper. Cheaper as in valuation relative to growth.
In 2007, value was as richly priced as we’ve seen in 30 years.
Other than the summer of 2020 and the tech bubble, value is the cheapest it’s ever been.
It’s fine to make a bet when valuations are stretched to extreme levels. The question is how big of a bet do you make given the signal.
Value is at the 98th percentile of relative valuation right now.
The linkage between interest rates / real interest rates and the growth / value cycle is very weak.
The mistake 99% of investors make with some regularity is buy high and sell low. When an asset has returned a lot, you should think about selling. You should always have an exit strategy when investing in growth assets.
For value strategies, always have an entrance rule. Arnott buys value when it’s cheap relative to fundamentals and the asset is no longer in freefall.
Meb Faber Podcast Guest (May 19, 2021)
The stimulus and the retail community have been massive for the stock market. Part of this was stimulus that wasn’t needed. People got stimulus checks and popped them in the market.
Stimulus is highly correlated with future corporate profits. The notion that stimulus helps main street and not wall street is utterly naive.
Printing money and using it to spend on chosen projects is a form a central control that isn’t effective.
Shiller P/E ratio is at 34 & was only lower during the dot-com bubble. Price / Sales and market cap / GDP are higher than ever in history. These are daunting multiples.
Europe is priced at half our multiples.
When things break, they break fast. We know this from the COVID crash, tech bubble, and global financial crisis. The majority of losses can happen in 6 weeks.
According to Fama/French, value peaked in 2007. According to P/E, value peaked in 2013. They all hit bottom in August 2020. They’ve since snapped back.
Value had a drubbing. The biggest and longest value drawdown in history.
Value was even cheaper relative to growth in 2020 compared to the peak of the tech bubble.
Definition of bubble:
- You need to make implausible assumptions in the valuation model
- None of the marginal buyers use valuation models
“Bubble assessment” for some current valuations:
- Amazon is priced for aggressive assumptions
- Tesla is priced for growth that wouldn’t be remotely plausible and nobody buys Tesla on a valuation model
They predict ~2% returns in the US for the next 10 years. Yield is 1.6%.
Lots of international and emerging market assets are priced to give much better returns.
Half of Arnott’s assets are in emerging market deep value stocks.
Meb’s whole 401k goes into emerging markets.
Arnott has noticed that the reaction is often anger when he challenges conventional wisdom.
EAFE is at a CAPE of 18. Emerging are at a CAPE of 15.
Emerging markets have their version of FAANG stocks. They’re called the BAT stocks. Baidu, Alibaba, Tencent.
BAT stocks are priced similar to the FAANG stocks.
15 years ago, there was nothing people wanted more than BRICs. 2000-2007, BRICs massively outperformed the S&P.
End of 2007:
- EM CAPE: 38
- US CAPE: 28
EM CAPE was a 40% premium, now it’s a 60% discount. Same companies & same countries still facing the same headwinds.
A lot of emerging countries are catching up economically by imitating and stealing ideas.
UK is almost the chepest developed market (Spain is slightly cheaper).
People send most of their investment research time thinking about buying. They don’t have any selling plan.
Rob Arnott has made a career of being curious. Whenever there is conventional wisdom, he’ll run a test to see if it’s demonstrably correct with historical data.
Arnott holds his beliefs lightly.
Since the top of the tech bubble, long bonds have outperformed stocks. There have been 40 year periods where bonds have outperformed.
In 2000, long bond yields weren’t bad and valuations were in the stratosphere. Now, long bond yields are terrible and valuations are in the stratosphere.
Rob has been called a permabear, but in his whole investing career, he’s actually never had a meaningful cash reserve.
The average emerging market allocation for US advisors is 3%.