← Excess Returns 
Excess Returns
The Water No One Can See | Graeme Foerster on Six Courageous Questions for 2026
01:00:11
Loading summary
Transcript146 lines
- [00:00]
A
An investment environment can become so familiar as essentially to become invisible. And that's where the danger lies. When a trend goes on for a long time, it just creates distortions. And the global economy is dynamic and distortions create pain. And so pain creates inertia for change. When China came into World Trade Organization, it kicked off this self reinforcing cycle. So if you go back to the implications of a change in the water.
- [00:27]
That is a shift away from the previous self reinforcing cycle.
- [00:32]
That would not be a real change in the type of assets that deliver for investors in the coming years. My overriding fear, because I acknowledge all of the bottom up attractions of China, my overriding fear is that if you look at the history of when two superpowers have clashed and there's a growing one challenging an existing one, it doesn't tend to end well.
- [00:59]
B
Graham, thank you for joining us.
- [01:02]
A
Thank you, Jack. Great to be here.
- [01:04]
B
You guys wrote two excellent papers that we're going to discuss today. One is six courageous questions for 2026 and the second is Sunrise on Venus. And they get into a lot of the issues all of us have been thinking about as investors. Thinking about international versus us. What's changing over the dollar, what's changing in the Trump administration with the US Policy, so many different things that are really important for investors today. So we're going to work through those one at a time. But first I want to compliment whoever comes up with your paper titles. Does an outstanding job because I end up with titles for our YouTube videos. I've kind of become a connoisseur of titling. These are both outstanding titles.
- [01:43]
A
Yes. Not me, but yes. Great writers here, great writers.
- [01:47]
B
To start digging into the paper. I want to start with the six courageous questions for 2026 and we're going to work through them individually. Six different people actually wrote each section of it. You wrote the one are you swimming in the right water? Which we're going to start with. But we're going to go through the different sections because I think these are all questions we should be asking ourselves. And also I think just the idea of asking courageous questions is so important because investing, we get so trapped in what we think and we don't want to go outside the box and we don't want to ask the tough questions and it ends up with us sometimes making suboptimal decisions in our portfolio. So I want to start about this idea of asking courageous questions. And what gave you guys the idea to write this paper around that topic?
- [02:25]
A
Well, I'll start by Saying, it's nice of you to say that the papers were good, and so.
- [02:33]
We really appreciate that feedback. We've not been a firm to. That's been particularly good at communicating our views. We're really just focused on doing the right thing for clients and making sure that our portfolios deliver for our clients. But we thought it would be a nice thing to do because we're such a diverse culture here where.
- [02:57]
Individual decision making is such a big part of our culture, that we always have so many ideas and so many diverse ideas. And so we've always thought that putting our stuff out there is hard because we don't have a firm view. There is no. There is no August view. So this. This six questions was nice in the sense that you can take a lot of different views and put them together as, you know, one of the most interesting things we're thinking about, and it has gone down very well.
- [03:24]
B
Yeah. It's interesting, too, because the way you frame that is important because the ability to ask questions, investing in not having maybe views you're stuck in is. Is so important. The. The ability to think outside the box and say, not like this is our firm view, but instead to say, like, we want to tackle this issue and we want to look at both sides of it. And that's what you guys did a really good job of, that inside the paper.
- [03:42]
A
Great. Yeah. Yeah, I appreciate you saying that.
- [03:45]
B
I was mentioning before we started, you mentioned one of my favorite commencing speeches of all time in your session, which is David Foster Wallace's this is Water. So I'm wondering maybe to start, could you just explain what he said in that speech and how it relates to what you were trying to get across in your section?
- [03:58]
A
You wrote. Yeah, I mean, we were talking before this, and you. You mentioned you're a big fan, and I had never heard of it before, and it just. I came across it maybe two, three years ago, and I read it in transcript rather than listening to a speech, and it just had the same effect on me. And so that I believe it. The speech was a mid-2000s.
- [04:23]
Commensurate speech, and it's not about. We talked about fish, a parable about fish, which was used in the paper, and it was used in a commencement speech as well. In a commencement speech isn't about fish. It's not about investment either. And the theme of the speech was, effectively, that we all have this kind of hard wiring that puts the self at the center of everything we do. It's very natural. You're the center for your world, you're the leading actor, you're the leading role in your own life. And that's, you know, it's very natural, but it's not necessarily very healthy. So the speech explores how to get sort of free of this hardwired default or try to at least try to get free of it, to break from the self and develop some degree of empathy. I think empathy runs through the speech and I think humility runs through it as well. And that's how I interpret it anyway. I mean, I think there are a lot of different interpretations you can take away. We use the fish story and not as nicely as Wallace did. And it works better in that speech than it does in our investment analogy. But essentially the story is an old fish comes across two younger fish and the older fish asks, how's the water? And the young fish swim away and one turns to the other and says, what the hell is water?
- [05:49]
And it was a story that relates, I think, to most people having little cognizance of anything outside of the self. So they're not even really aware that they're locked inside their own minds, inside their own thoughts. We use it here to refer to the investment environment. So it becomes an investment environment can become so familiar as essentially to become invisible. And that's where the danger lies. So we get so used to how things are and things can stay as they are for awfully long time, decades. And so people stop really paying attention and they don't even notice the water, even as things start to shift.
- [06:29]
B
Beliefly.
- [06:31]
And to your point, I'm a US investor and I really never thought about relating to speech to investing. But when I read your paper, I'm like, yeah, this makes complete sense. Like not just myself, but like the US investors I talk to, like US stocks and bonds is our one. It's all we think about, it's all we think we need. You know, we don't think about international diversification. And a lot of that is driven by this period of 30 plus years or whatever it was, where that's just what's worked. But you argue in the paper that maybe some of that is changing. So first, can you talk about maybe how we got to that point, how we got to the point where the USP came, like the place that was outperforming everywhere else. Yeah.
- [07:06]
A
So we describe it as a. I think it's a self reinforcing cycle. And those are the, you know, self reinforcing dynamics, are the things that last long, can last a long time. So, you know, I think of the water as this self reinforcing cycle that we've been in. It's been around 25 years, I would say, or maybe a little bit longer. And so it's all most of us, as you say, it's all most of us investors, investors of their own. And I would argue that the dynamic has had a profound impact on asset pricing and cost of capital, on winners and losers, on currency, on fiscal policy, et cetera, et cetera. So it's all connected to this dynamic. So around 2000 was the last time that the US ran a fiscal surplus. It's been a long time. I don't think it's a huge coincidence that China entered the World Trade Organization. A lot of people know that around that time. And so China and a lot of countries, similar countries like Korea, Japan, Taiwan, even western countries like Germany, but with China really as the largest and most important in this sort of dynamic. They all ran a specific model and we're all familiar with it now. It's keep your currency cheap, keep labor cheap and export. And the biggest consumer market in this dynamic was the us There are others, but the US and China were the kind of dominant actors, if you like, in this, in this sort of cycle. So this kind of. When China came into the World Trade Organization, it kicked off this self reinforcing cycle. So China exports to the US and then it collects the excess savings in dollars. So that's Greenspan Savings Club that we used to talk about a long time ago and now these savings went back into the US to finance further purchases and from China. So for further sort of exports from China, self reinforcing because the flow of excess savings pushes up asset prices, pushes up housing, pushes up stocks and it pushes down interest rates through the purchase of Treasuries. And so that's great for consumers because they can, they've got more.
- [09:18]
Higher asset prices, they've got more money in their pocket, they spend more on imported goods, that leads to more capital inflows. And round and round and round it goes. And you could also look at the suppression of US interest rates that helped kick off one of the biggest fiscal binges in history, which also massively supported the US consumer from round and round it went. So now we've got a 6% of GDP fiscal deficit in the US and 130% of debt to GDP which I'm sure we'll get into. And other importer nations are not much better. So the uk, France, Canada, et cetera. But the UK is worse and I think it's in the center of this dynamic and where this imbalance, this trade imbalance has been in both trade and savings.
- [10:03]
B
As you mentioned, once these cycles get going, they're challenging to break, but we are seeing some signs that this particular one might be breaking. So how are you thinking about what's changed in terms of that cycle and what it means going forward?
- [10:13]
A
So a bunch of things are happening at once. There's macro, there's political and there's micro. There's.
- [10:20]
As a reaction to kind of the water flowing in the same direction for a long period of time. And I don't think that's a coincidence. We're seeing all these things changing at once. When a trend goes on for a long time, it just creates distortions. And the global economy is dynamic and distortions create pain. And so pain creates inertia for change. So at the macro level, we've seen increasing dissatisfaction. We know this from populations in deficit countries especially. And this has led to a change in the political leadership is really just a reflection of the will of the people. And the political class are now acting to push against the pervading trend, the flow of the water. So tariffs are one big sign of that. That's a tax on imports and that acts to stem this relentless flow of exports we've seen on these trade imbalances. On a more micro level, which people don't talk about so much, we're also seeing action, especially from companies and economies that have kind of suffered under this backdrop. You don't think of the consumer economies of South Korea as a net loser, but they have been because you kept the currency low and you've kept the wages low. So consumer businesses in Asia, such as South Korea have been net losers as the currency and labor costs have been held down as a result of excess savings flowing abroad rather than supporting any kind of domestic agenda. All the savings of the left and over the US So in my view, this, this kind of contributed to a prolonged period of, of poor corporate performance, especially in surplus countries and share price performance and especially again amongst Asian domestic businesses.
- [11:57]
And I think this is catalyzing change at both a country level. So you can look at Korea's value up program, you look at Japan's corporate reform program as examples of that. You see more fiscal stimulus in those countries which is effectively domestic investment instead of money going abroad as money staying at home and at the corporate level. So we're seeing various initiatives to boost performance at the corporate level just because performance has been so bad for so long. So if you go back to the Implications of a change in the water.
- [12:25]
That is a shift away from the previous self reinforcing cycle. That would be a real change in the type of assets that deliver for investors in the coming years and maybe even decades. Businesses have struggled under the ones that have struggled under the previous regime, the shares of businesses that have struggled under the previous regime. So domestic Asian businesses are an example gradually now start to see their earnings start to grow and they start to see that the currencies in which those stocks are priced appreciate. And you see multiples start to go with them. Because once you start to see currency going up, once you start to see the businesses improving and the multiples come, start to come back. Whereas assets, and those are the businesses that have performed very poorly for decades. Whereas assets that we've grown used to seeing appreciate relentlessly year after year after year gradually begin to struggle. So think US domestic assets, real estate, et cetera, as the cost of capital finds a higher level because it has to now this reinforcing cycle has slowed down and the flow of capital into the US starts to wane.
- [13:29]
B
Yeah, it's so challenging because to your point, some things are changing significantly now that are probably more long term changes in terms of this. But those of us that have had international exposure in the US like I have for, for our clients, you know, we've had so many fits and starts over the years where we're like, all right, international is back and then it's not back. So we've almost been tricked into thinking, you know, that every time this, this happens, it's, it's fake. And now maybe we, we lose sight of these big trends. Maybe we are seeing the structural change now.
- [13:56]
A
I think so. Are these classic.
- [14:00]
If you've got a really long cycle, you're always going to have a lot of false amounts. And what happens again also after a long cycle is portfolios get really clustered into the same assets. And this is really true today, given we now live in a world of kind of heavy indexing and benchmarking. And to put a sort of an exclamation point next to that, we run really active portfolios and we've delivered good returns over long periods of time for clients. So you'd imagine, you know, when we got a client in the US and elsewhere, we'd be in reasonable demand for, you know, for what we do. And we are, you know, we've got good aligned clients who've been with us for decades. But the most common thing we hear when we speak to prospective investors is, you know, we like you, but you look a little risky. You say, why do we love risky? You know, you know, we've got good businesses, we have a lot of big discounts, we've got a nice diverse portfolio, we don't run huge positions. They say, well, look at your active shin. So they're really comparing you to the benchmark. So the degree to which you differ from the benchmark in most allocators minds is considered to be risk. And they say it's a little bit high. It's a little bit high.
- [15:12]
And we say, well, how are you measuring risk? But it's not the allocator's fault in my opinion. It's the incentives that cascade through. Everyone's worried about one year performance, two year, three year, four year. Nobody's thinking about long term. And if you think about how exceptional wealth creation is delivered, there's only two things. You've talked about this before, right? It's time and it's return. Your podcast is called Excess Return. You put the time and the excess return together and you just get these explosive results. You know, it's unbelievably simple. And nowhere in that equation is active share. Nowhere does it say you've got to keep your active share low. That's the secret of growing your wealth. Yeah, it's absolutely pervasive. And in my opinion it's this kind of short termism and it's crazy. It's crazy to think so short term in this industry because you know, time is so powerful.
- [16:02]
And if you benchmark yourself, you're constraining yourself to just looking in these areas which are dominated by the big stocks.
- [16:11]
So it's not just the passive investment that's a big deal. It's even in active investment. Yeah, clients or investors are looking for low track. Notice a rant over. But that's, that's, you know, I hope with a changing backdrop that we might be seeing, you could catalyze some change in that as well. And I think you need a bit of a shaker to your point.
- [16:34]
B
When, when the benchmark is the first thing people look at. It can be okay in certain situations. I mean, obviously we know many active managers produce value relative to the benchmark, but it causes a bunch of problems too because the things you do to be better than the benchmark, you almost get punished for doing those things because it makes you different than the benchmark. It becomes a challenge.
- [16:53]
A
And most managers are not on good incentive schemes where they have nice aligned incentives with their clients. And another big sort of bugbear of Ours is the number of clients that are on fix, number of managers that are on fixed fee. And then it just incentivizes growing aum. Growing AUM is the enemy of returns, generally speaking. And if you want to grow your aum, you don't want to take much risk. You want to stay close. You want to really stay close to the benchmark, take little risks, risks in inverted commas. And then that's what we see. That is pretty pervasive when you think.
- [17:33]
B
About the US outperforming. I'll put up this chart you had in your Sunrise on Venus paper. You broke down the performance of the S&P 500 into the sub components. So the return. Then you broke down the sales growth. How much was sales growth, how much was margin expansion, how much was valuation change and how much was dividends. And a big portion of that is fundamentals is that these were really good businesses. And, and that's sort of the counter argument that I wanted to ask you about this idea that these US companies, these big US companies are such great companies that they're just going to keep growing forever. You know, they're going to keep producing great fundamentals and that gives the US advantage. An advantage. Like, what do you think about that argument?
- [18:09]
A
Very valid, but I would just reframe it. So when people think of the US they think of the Max 7. And in my opinion, the Mic 7 is in the US or the. What was it before the max? There was some of the record.
- [18:24]
B
There's been a. Yeah, many of them are underway.
- [18:26]
A
The Fang, Remember the Fang and the.
- [18:29]
B
Fang had one A or two A's, I think. Depends. Yeah, there's been so many of them.
- [18:34]
A
So for me, that's just a collection of companies. That's not the U.S. that's just a collection of what, max 77 companies. So the U.S. is a broad selection of shares. If you, if you break down the return of the average share in the US over the last 15 years, you'll see a good return, total return well above normal, which is around 13%. So very high risk $. And.
- [18:57]
You can break that down. So we say, where does that come from? And one.
- [19:02]
You can break that into four pieces. One of them is the sales per share growth, another is the dividend yield. If you put the dividend and the sales per share growth together, you get around 7% for those two. And 7% is a normal return for a market. Right. You look at your triumph for the optimist to go back and look at many markets for over a century and they see 7% is some magic number. The reason it's a magic number is it's an equity risk premium plus a risk free rate. And the risk free rate is normally 3. And equity risk premium, the extra risk you take for taking on equity is 4. So that's 7. So on average you get 7. And the average share in the US has done 7. And they've done it through sales per share growth and doing a deal. But it's also delivered more than that. And the way it delivered more than that is through a couple of nice extras. Margin expansion gave you an extra 2.5% year and valuation change gave you another 2.5%. Yeah, so you got an extra 5%, you know, 5 or 6% versus normal. So to get 13 or 12 or 13% going forward, you need these extras, these little extras to happen again. Okay, so you need valuations to go from high levels to very, very high levels. And another give you that to continue giving you that 2.5%. And I think the valuation pickup has been the. Around this dynamic we talked about. It's been the water, it's been the flows into the US the savings lot and other things, and it's been a cost of capital dynamic because you're keeping those interest rates low over long periods of time. And they're both, in my opinion, they're both gradually reversing together. There'll be a recognition that long rates aren't going to drop back down to very low levels, et cetera, because, you know, this dynamic is going away and margins is really the unknown. Maybe margins can keep going, but there's only so much you can optimize in a business.
- [20:44]
B
And I think that was an important point you made in the paper is you looked at margin expansion and said, all right, maybe some people think this can continue. Let's carry this forward to the future. And let's say, what does this mean? Margins eventually get to. And you had margins, I think by 2040, reaching 19%, which when you think about it that way, you're like, all right, maybe it can't continue. So I thought that was an interesting exercise just to look, if you carry this through with logical conclusions, what happens? And do I think that's reasonable?
- [21:10]
A
Yes, that's right. You do have both the valuation and margins. And you get to think, well, you know, it could happen, but what's the balance of probabilities?
- [21:16]
B
One of the other things you did in this paper that I thought was good is you looked at, you guys, you guys calculate expected returns for Stocks and you do it within the US universe and you also do it in the X US universe. Can you just before we talk about like what you found in the paper, can you explain how you do that, how you think about calculating expected returns?
- [21:32]
A
So for expected return we have evaluation model for every.
- [21:36]
Every stock. It's quantitatively derived.
- [21:42]
But it.
- [21:47]
Which means at the stock level it's noisy and often wrong. So it's not. What we do is we look at a business in depth and we'll value it based on deep knowledge. This model doesn't do that.
- [22:01]
It uses breadth rather than. But what we find when we use these models is when we aggregate over a large number of stocks, they're quite often quite useful. And so the models are effectively discounted cash flow models for every business in the world. And that gives us an expected return.
- [22:19]
B
And to your point about aggregation, I'll show the two charts here. But what you showed in the paper is that basically when you do that a very low portion of US stocks have high expected returns, but a much higher force of international stocks, which is great for an active manager because you have a much better pool to select from when you look in the international universe.
- [22:35]
A
Yeah, exactly. Yeah, yeah. So I don't want to bang the drum too much for X US and US because I run an international fund. So I'm horribly conflicted. But there are a few things here. So first it's clear to us that if you do a like for like comparison of stocks listed inside the US and listed outside the US there's a discount outside. So you can look at that chart, you can look at other things, you can look very like for like businesses. And I think you need look no further than the number of non US listed companies looking to list in the US so as to get a premium valuation. If you don't believe me, look at the actions of corporates. Second, here.
- [23:16]
In a pitch for international equities, given such a long period of flows coming into the US the number of eyeballs actually trying to assess the true value of non US shares has completely diminished. So I would argue that inefficiencies or mispricings which outside of the US are now much more prevalent and that's probably the most important point. If you want excess return, going back to excess return plus time being the key to long term wealth creation, I think going active non US.
- [23:46]
Is a good time to do that. Third, from a risk management perspective that we mentioned earlier, there's way too many eggs in one basket at the moment. People think about risk is tracking error. And they're measuring tracking error against a very concentrated index. And they're saying the more I can get close to that index, the less risky I am, which is crazy. And finally, you know, if, if we're right about the change in the water, you know, that will benefit non US currencies as well as equities. There's very, some very discounted currencies out there. So arguably you can find triple discounts, mispriced equity.
- [24:23]
In cheap markets priced in undervalued currency.
- [24:27]
B
And your point about currency leads into the next question you guys had in the favor, which is, is the world's safest currency actually the riskiest? And you know, this is interesting because as a non US investor, this is something you have to think about a lot more than me. Like I don't, I don't have to think about the dollar that much, but everybody's sort of taken for granted. The dollar just goes up. And we put a chart in one of our previous podcasts we did with one of our guests and the chart of the dollar going up is pretty impressive when you look at it. And even the most recent decline is just sort of a blip relative to that long term trend. But I think you guys think maybe there's the same factors we talked about earlier might be breaking that trend.
- [24:56]
A
So am I right about that? I think so, yeah. And, and you know, you never know these, you usually have to look back in 10 years and in, and in hindsight it just like, oh, there is. And when you're right in the middle of it, you, you don't really, you know, it's just, it looks like noise and you know, things are wumbling around and.
- [25:16]
But I think it is interesting that the US dollar has been a nice diversifier over the last decade in market shocks. It's been this flight to safety currency.
- [25:25]
And I think we're starting to see cracks in that. Not clear cracks, but the drawdown we saw earlier this year, for example, did coincide with the weaker dollar, which was quite unusual. It also coincided with yields going up, not down unusual. So I think you're starting to see evidence that the border water's changing and we should pay attention to that.
- [25:45]
B
To your point, I'll put the chart in there you had in the paper, which is great because you see in every one of these previous declines, you know, S&P 500 down dollar and then the most recent one, you don't see that anymore. And I was also thinking back to, you know, in the US when We went through the whole tariff thing. We saw a situation with stocks down, bonds down, currency down, that we hadn't seen in a long time. So it is as if something, something is changing here. And you know, that'll change a lot of people to, to our point we talked about before about this gets embedded in people's minds. It's the dollar is not the thing that goes up when we have these prices. I mean, that'll change a lot of things and it'll probably take a while for all of us to adjust to that because we're so used to it.
- [26:20]
A
Exactly. Yeah, that's right. And that's the water. You don't notice it and all of a sudden it starts to be very, very nervous.
- [26:27]
B
To your point of view, the water will probably carry through, although we're doing six different questions here. The water will probably carry through all.
- [26:32]
A
The way through that.
- [26:36]
B
So question three was what if American exceptionalisms now lies beyond America's biggest stocks? And you talked about that before and as a guy who's a value guy in the US it definitely hits home for me because I, I'm primarily investing in stocks that are not America's biggest stock. So how do you think about that idea? And obviously we've had a lot of trends that have benefited these biggest companies in the US but we've got a lot of value potentially in these stocks that are not the biggest companies. So how do you think about that and the potential of this change?
- [27:00]
A
So I would say high. I'm not dogmatic here. Again, going back to the top Shares are just 10 shares.
- [27:12]
They have shared characteristics, but they also have idiosyncrasies. And they're not all priced the same way. We've had a selection of them on occasion where we believe there's a mispricing. I don't subscribe personally to the view that they're wildly overpriced, but that said, there are 5,000 plus possible equities that you could own around the world. And what chance that even one of these particular 10 are amongst the, say, even the 50 most misunderstood on this price? A very low chance. So on average we'd have some, but we've not held them. And I think it's people get caught up in a group of stocks that have done particularly well. But you've got to remember there's more and more differentiation between them. Stocks have come in and out of that group and there's plenty more ideas in the world that look much more interesting.
- [28:12]
B
Yeah, we all kind of get trapped and we see these companies in the news every day and we see them grow maybe at levels that huge companies haven't grown in the past and we think it can go on forever. But one of the interesting things, if you look back at the top 10 companies in the S&P 500 by decades, they usually change a lot. Like a lot of times we thought the ones 20 years ago couldn't be, you know, couldn't be beaten by anybody. And they do get beaten. So it does get harder and harder as they get bigger and bigger to sustain this growth and to sustain this dominance.
- [28:37]
A
Exactly. I agree.
- [28:38]
B
What do you think about like when you do look inside the US When I was reading your paper, you guys highlighted healthcare and founder led companies. Like when you do look inside the U.S. are there certain areas that you see as particularly attractive or the particular types of investments you look for?
- [28:51]
A
Yeah. So we're looking for discounts wherever we can find them. And we very much believe that you want to keep your investment universe as wide as possible because inefficiencies can happen anywhere.
- [29:04]
And one of the reasons we've added a lot of value.
- [29:07]
Over the decades is the capital in the portfolio. Going back to the water analogy, I think of it like water. I think of the capital in the portfolio should flow without friction into the biggest mispricings. And the market's always changing, prices are always moving and there's always dislocations and it's just a question of being on top of the true value of the businesses across as many things as we can look at and take the opportunity when the prices give you that opportunity. So one area that we're finding interesting at the moment is healthcare and biotech, which is quite rare for us. So biotech is normally bid up and there's a lot of excitement embedded in the sector because it's a very innovative and growthy sector.
- [29:54]
So we're really excited that we have the chance today to own some of those companies. Because since COVID we went through Covid and they had a big biotech boom. And then since then we've seen an epic bust. It's first through the COVID receding, then interest rates suddenly moving up, which is bad for a sector like a growthier sector like biotech. Then geopolitical most started around drug pricing, then AI came along and started sucking up all of the innovation capital. And so biotech is just left there and there's a real opportunity. And so we've been able to pick up some amazingly innovative businesses run by incredibly talented scientists and Management teams that trade at less than the net present value of their currently marketed drug drugs. So you get on the platform for free, for example. So it's a rich scene.
- [30:49]
B
Have you changed how you think about valuation? Like one of the things we've struggled with in the US is this idea that we've got these different types of companies, these high intangible companies that are becoming bigger and bigger portion of the market and intangible assets are becoming more important. Like do you guys still think about valuation the way you always have or you had to maybe modify that for like a new economy type stock? Right.
- [31:07]
A
Well, you always have to have a nuance view of valuation. You can't just run the same thing on every business because every business is slightly different. But I think one of the core of what we do is cash flow. And it's nice if you're just looking at cash flow because you know, intangibles and tangible assets can generate a lot of cash flow.
- [31:29]
And so, you know, if you're. We haven't adapted our approach, particularly because of the way the economy changes, because we know the economy is always changing. And if you're focused on cash, I think then it makes you a little bit more immune to changes in accounting and changes in technology and changes in the way the businesses work.
- [31:51]
But you always have to be alert to new business models emerging and willing, I think, willing to be open minded and thinking about the disruption they cause and how those business models can potentially generate a lot of cash over time.
- [32:10]
B
Well, question four, I'm hoping you have the answer because I've been thinking about this one a lot myself and I think the market is as well, which is, is AI a bubble or is the best yet to come? So I'm just starting at that at a high level, like how do you think about defining a bubble? Like do you as an asset manager, do you care if we have a bubble in the market? Like do you think about what the definition of it is or are you just looking at companies and you. That's not really something you would think about.
- [32:32]
A
I care very deeply about bubbles, very deeply.
- [32:37]
And the reason is that bubbles in my, when I think about bubbles, I think of massive overvaluation and that that offers an amazing opportunity to do a huge service for your clients by not investing in the assets because probably they have quite a lot of capital invested there. And so, you know, over the years we have been.
- [32:59]
Helpful, I think, to clients in avoiding sidestepping some of these inflated areas. Now they're not, they're Pretty easy to spot in hindsight. They are in real time. So I'm going to be horribly on the fence here, but I'm going to say.
- [33:19]
If you ask me, does AI meet the definition of rebuild? I would say maybe. And what I find most interesting is kind of the game theory dynamics of the big spenders. So I would describe the business leaders of today as the kind of Star Trek generation. They're the tech nerds, right? The tech nerds rule the world. And I always thought that'd be a wonderful thing. Tech nerds, they're smart people. It'd be great if they ruled the world. But I don't know. The ones that are floated to the top are not the ones that are US school today. So we shouldn't underestimate the degree to which these leaders just want to find out how far they can push the technology to get to superintelligence. And that's all they want to do. And that's the sort of primary motivation.
- [34:03]
So to a degree, I think they just want to throw as much capital at it as possible. And that generally is not a good recipe for investment returns because, you know, a lot of capital drives prices up. You end up with a very, very painful capital cycle. That said, the end product is quite good.
- [34:21]
I'm sure you're using it. We're using it a lot.
- [34:23]
B
All the time.
- [34:24]
A
All the time. And the capex they're putting in to this technology, while it's very large, is constrained, it's constrained by energy, is constrained by chips. So the rate of capex growth, although again has been quite spectacular, hasn't been as quite as asymptotic as it could have been because of these constraints. So I say I'm cautious. But you, you know, we're not, we're not completely avoiding the area, we're trying to look for good risk return.
- [34:54]
B
And it seems like when you think about bubbles, that that's probably the only thing you could do with an investment manager, right? Because these things can go on way longer than you think. You know, you don't, you obviously don't short anyway. But even if someone was shorting, like they wouldn't short the bubble. It's like all you could do is try to find things that you think are not participating in the bubble, that you think are attractive investments and invest in those. Right. And that's, that's probably the only thing you can do in the case of.
- [35:13]
A
One of these things, I think. So I think we, you, I don't think you should invest on the basis that, you know, you might get left behind. I think that's, that's, I see it, I see the dynamic and the fear of missing out and all the rest of it, but I think that's not doing a service to your clients because that explicitly says that you are investing in things that are very risky because they're massively overpriced, but you worry they're going to double again. What I would try to do though is so, so if we were in a situation where the valuations were so high that we can't, we couldn't make the numbers work anywhere, we would not invest and that would be fine. We might underperform, but that's okay because our clients know what we do. But I think if you look at what we're seeing today.
- [36:00]
There are still interesting opportunities. And as long as you're balancing everything with the valuation lens.
- [36:09]
Then you're on safe ground. Everything has a range of outcomes. So this is the way I would think about it. Everything has a range of outcomes and you make sure you're not paying a price which embeds that right tail. So the really kind of rosy outcome, if you're paying a price that sits in the middle and we know AI is going to be big, so we can embed quite rosy assumptions in there, but don't pay a price that embeds some crazy right tail outcome.
- [36:33]
B
Do you have any thoughts in general on all the AI capex spend? It's something we've been talking about the podcast a lot and thinking about a lot. And if you look back to other capex spends, whether it's the railroads or the Internet, they obviously made huge changes, were hugely beneficial to society, but they weren't necessarily beneficial for the people that were spending all the capex. Do you think it plays out like this again this time, or do you think AI is maybe more transformative technology? So we have to look at it maybe a little bit different than those previous ones. I'm just wondering if you have any thoughts on that.
- [37:00]
A
I think, I mean, all these technologies are very transformative.
- [37:05]
And I think we're seeing the same dynamic. So you just need to be very careful if you're, if you're, you know, putting money into the same things that everyone is putting money into.
- [37:16]
And I wouldn't be bullish on the prospect. So that's, that's where you kind of, you're seeing some of those prices embedding right to icons.
- [37:26]
I think again, you're getting back to the incentives, the Star Trek type incentives of you want.
- [37:34]
They want, they want to push it as far as they can go. And there's a small, tiny chance, I'd say tiny. I do think it's tiny that you get to some sort of super intelligence in some reasonable time frame in which case all bets are off on Capex.
- [37:48]
B
Right.
- [37:48]
A
It's just, just not changes things. But in terms of the tools we have today, incredibly useful. But given the amount of capital going in, I would be cautious.
- [37:57]
B
How much are you thinking about AI when you look at individual businesses? And I'm not talking about like the direct plays, but I'm talking about like all these indirect companies. I mean I think all companies will probably benefit from AI in some way. Like are you thinking about that a lot when you analyze companies like what will, how will this business change with AI? Maybe trying to find indirect beneficiaries of it.
- [38:14]
A
Yeah, I'm really nervous. We try not to do the same thing as everyone else but you know, there are times when the technology is very important and you need to be really thinking hard about what impact it's going to have. So pretty much, as you say, pretty much any company could benefit from AI. So you have that lens and then there are, perhaps we try to think of it as some, maybe there's some tangential ways to gain exposure to potential right tail outcomes, but without paying too much. An example would be SK Square, for example. And I'm going to go back to the water.
- [38:51]
So the SK2 is a Korean conglomerate. Its key asset is 20% stake in SK Hynix, which is a key player in the memory space. Memory is basically an oligoptery between Hynix, Micron and Samsung. And so SK Square through Hynix is a very direct beneficiary of the AI brew. A very direct beneficiary. It's almost right in the red hot center to the AI. SK Square has a 28 billion or roughly 28 billion market cap. And its stake in SK Hynix is worth 50 to 60 billion. So you get Hynix at a massive discount. And they also own other stuff as well. And that discount translates to something like a four times forward earnings you pay for Hynese today versus the 10, 11 times that you would be paying if you actually bought it direct. So you have the exposure to the continued AI Capex boom, which if we're in Star Trek world, it may well continue, right, Especially given the constraints and it may continue for a few years, but you have the margin safety through the discount. The kicker is, as we discussed earlier, back to the water, that Korea is experiencing a prolonged slump. Right. In a persistent equity market discount, and they're pushing for reform because they've had this big, long slump. And that's both national and it's at a company level. So we think that this discount should close over time. You know, we're engaging with a company and others are engaging with a company to.
- [40:12]
Bring that to fruition as we.
- [40:14]
B
Get to the fifth one here. And I will caveat this, as I always do, that this is not a political podcast. So we are not endorsing things one way or the other. Because whenever I ask the question, what if Trump is right? I have to preface it with that. But you are getting to this idea and you did a great job in the paper, you guys, of putting Maslow's hierarchy in the pyramid of sort of wants versus leagues in there and how that relates to what's going on in the world right now. So can you talk about that a little bit?
- [40:37]
A
Yeah. So I think it's another flavor of the changing water. That's it. Society goes through cycles. Once basic needs are met, shelter, food, security, et cetera, society moves up the pyramid to financial security and then to entertainment and then finally to self esteem and, you know, getting pronouns right for you. So you sit right on top of and. So in the west, we've arguably been through a period where capital, both monetary and political, has been flowing to the top of the pyramid at the expense at the bottom. So money's flowing to the top. It's not for a little moment. And look at national defense as a classic example. We underinvested for a long period of time in the peace dividend, in national defense. And now we're sort of C2B. So.
- [41:28]
So one thing that's interested us, going back a few years now, was the increasingly fragile Western energy infrastructure. So old power lines, transformers, effectively a brittle grid. And now you have AI coming into the picture. And it's interesting to think, you know, where AI fits in the pyramid. Right. You would think it would be the top. When you think about OpenAI sora, which is like TikTok but with AI slop, but it's, you know, AI is being reframed even there. And why is it being reframed? I think because people recognize that the bottom of the pyramid is where the capital is going to go. So the AI, the AI leaders are shouting the loudest that it's a national security imperative to invest in AI and which is very much bottom of opinion. So we do think if you consider the apps and the flows or Kafa cycles at the bottom of the pyramid has been starved. And we'll see more capital allocated to things like food security, energy security, et cetera, over the, you know, the social medias, et cetera, sitting at the top.
- [42:33]
B
And how do you think that changes how we all think about the investing world? That changed maybe from wants to needs. What does that mean for the investing landscape?
- [42:41]
A
I think it's all connected again, all similar dynamics we're seeing playing out. So the trade distortions coming to a head, coinciding with a refocus on needs versus wants, and then receding globalization naturally leads to a more domestic focus.
- [43:00]
And when you take a good hard look at your domestic situation in places like the EU and the UK and the us, Canada, you start to see how reliant on globalization you become and how many of your needs were met by other regions. Hence, you've got to get back to investing in the foundation and the bottom of the pyramid in your own country. And I think people have referred to it as state capitalism. It's something that China has been kind of following for a long time. We're seeing in many more countries. And all these savings that are built up around the world are just going to come back and be invested in their own country. Which I was so surprised when Trump started to push his domestic agenda.
- [43:43]
That one of the first people standing behind him in the Oval Office was.
- [43:51]
The founder of SoftBank, CEO of SoftBank, declaring he's going to invest so many billion. And I think he doubled it when Trump asked him to. Can you double that number? And he said, okay, okay, I'll advise that. And I thought, that's extraordinary because if I were, I'd be absolutely furious. I was sitting in the Japanese government right now saying, this is one of our national champions and they're pledging to invest billions in the US and not bringing that back home, where we need a lot of domestic investment as well, I think. So that will start to be the trend over time. You've just seen a populist government come into Japan, for example. She's talking about reinvesting in the country, just like Trump is. So all the capital's coming back. I think that's just going to be huge. And it's mostly that bottom of the pyramid type stuff that they're going to be putting their money into.
- [44:32]
B
Yeah, it's interesting, and you guys made this point a few times, I think the paper. But this idea that we're all just turning inward, like every country is turning inward and saying, what do we need? You know, we've learned that if we need some X, Y or Z that's essential to our national security from another country, that can go really bad for us. I mean, Covid was part of that, but a lot was part of that. And it seems like everybody's saying, now let's look inward. And it's so interesting to think, like, what does that mean? As we think about the investment landscape and we think about what we invest in, what does that massive change mean? It's something I'm still thinking through, and I don't know if you have any more thoughts on that.
- [45:01]
A
Well, yeah, I mean, you have to dig into what each company does.
- [45:06]
And you have to recognize not just what a country has already and where the money's going to go on that basis, but also allegiances. So the U.S. for example, can't build everything from scratch. They can't. It's just not going to happen. And same in the UK and other countries. So shipbuilding is a great example. China's building ships at a rate of knots, if you excuse the pun. And the US isn't. And.
- [45:33]
They'Re not. They can't just imagine it out of nowhere. Right. They can't build it. They can't rebuild their ship industry. So you have to leverage your partners. And not many have the capability. Right? Not many of your partners around the RAV have a real capability. So the ones that do have the capability, that becomes a very scarce and very valuable resource. And so that's the type of. You know, I think in this type of environment, you've got to be thinking, what's next? What's next? What's next? And.
- [45:57]
And there's always opportunities, especially in periods of change. If the water's been flowing one way for a long time, there's fewer opportunities because everything's bid up and people are riding the momentum train. As things start to change, there's enormous opportunities because that's the point where everyone's offside and it's going to take a long time for people to realize, okay, it's a different environment. We have to start doing different things.
- [46:21]
B
Do you think there's anything that could change this trend that's reversing? I think, like, and this is probably a bad example, but I think in the U.S. like, we'll have something major that's structurally changing and, you know, a major situation in the market, and the Fed will come in, you know, inject massive liquidity or something.
- [46:36]
A
I think that's the expectation. I Think, you know, most investors are thinking, well.
- [46:42]
It just takes an interest rate cut or you know, or also more qe. And we're back to where we were. And that's great for asset owners, you know, that's, that bails us all out and off we go again to the races. But I mean you listen to some of Besant's speeches before and after he got into the treasury. He's all for normalization in some of these dynamics because he thinks it's very distorting. And he's right. It's been hugely think about the US housing market, there's enormous distortion there and everyone thinks oh, you know, it'll work itself through. But you know, you have a 30 year mortgages, so that's fixed mortgages over 30 year periods underpinning the whole market. And those mortgages are based off a period where interest rates were uneconomically low, massively uneconomic to the point we used to talk about the term premium. The term premium is a piece of that long term yield and that, you know, I'm not going to go into the details of the term premium but it's essentially like a risk premium around inflation expectation. And risk premium should never be negative. Never. But it went to negative 2%. Unbelievable. That's a clear TMS pricing in long bonds and long bonds underpin the market. And everyone underwrote this housing market with these low rates. So you've had so much capital distortion. So I think there's a recognition you don't want to go back to that. Right.
- [47:58]
But I would say that.
- [48:02]
With humility there are a range of outcomes around every situation. And it's worth noting that at this point.
- [48:13]
We'Re heavily bottom up. And despite all these macro threads we're talking about today, you can always put a portfolio together with idiosyncratic differentiated ideas and make sure you're not carrying too much of risk that you know that if interest rates get cut or et cetera, et cetera, et cetera. So I think you just need to be cognizant of what it might be changing that leads a great opportunity, but it might not. So just, just build a portfolio that's resilient.
- [48:39]
B
That's actually an interesting question. Like how bottom up can you be in terms of like there's always this balance between you want to pick stocks that are great, but you also maybe have to at least think about some of this other stuff. Like how do you think about that as a manager? Like how much are you concerned about this other stuff? And how much do you have to say? I just need to buy great companies and everything will work out?
- [48:56]
A
Well, I mean you, I always say that you can't be macro agnostic. It's just like it's nonsense. You read because the assumptions, the macro assumptions are going to feed into your valuations and what you're doing is valuing companies. So you know, interest rates are going to be 2% lower. That's important, right? That's going to. And you can see that in the 2009-2000-2020 period, which was incredibly difficult period for active managers because the term premium went 2% negative. And so it said growth stocks to the move. Right. If you, respectively, growth stock, if you're a biotech company or whatever, you get cheap capital and that changes the whole dynamic that sources reflexivity and all the rest. It. So it's super hard. It's super hard. But you know, so you can't, you can't build a portfolio, be resilient around anything. But just don't put all your eggs in one basket.
- [49:46]
B
So question six, which is a great question and was a question maybe we would answer differently a couple years ago, but the question is which risk runs deeper? Owning or avoiding emerging markets. In, in this case, the avoiding has been the one that's been, been riskier. But, but how are you thinking about that? I mean, emerging markets have been cheap for a really, really long time relative to the U.S. but the U.S. has been doing so well fundamentally. Like how are you thinking about that balance between the cheapness of emerging markets, maybe maybe some of the growth in the US but also in light of all these trends we've been talking about in terms of things reversing in terms of US dominance. So how are you thinking about averaging markets right now?
- [50:18]
A
Yes, I mean assessing risk versus reward is kind of what we have to do all the time and quality versus price you pay, et cetera. So as we know, the growth of quality, it should come with a fatter multiple. But you have to kind of run the numbers to see what that premium should be.
- [50:37]
I would push back on any argument to say that the US has better quality companies in Asia. I think there's a lot of great businesses in Asia markets. TSMC in my opinion, is the most important company in the world by some margin. So AI Nvidia, Tesla, exceptional. It would not exist without tsmc. They are truly exceptional, maybe even in the history of the world. I don't know. That's a big statement. But I think they are absolute linchpin and that's no longer contrarian at all, but it's still no less true. There's companies like sea, which is a fast growing ecom business in Southeast Asia. Amazing quality business, great management culture, good capital allocation acumen, et cetera. So on average.
- [51:23]
You, you can earn these businesses with a reasonable multiple because you know, the way they trade and get the, you know, the quality that they carry as well.
- [51:35]
B
You guys had a great chart in the paper because we think about valuation and future returns and I think a lot of us in the US have maybe thought like those don't have anything to do with each other anymore because valuations have kept going up and up and up. But you have a great chart here that shows that it really does matter. Both in the US and in the emerging markets, there is a relationship between the valuation and what return you would expect to get over a long period of time going forward.
- [51:55]
A
Yeah, again, you go back to the water. If there's a long period where flows are distorting things, people think, well, these things don't matter anymore. But they absolutely do. And you know, the companies will change their behavior. You know what we're seeing in Korea now, for example, because they had such a long period of that discount getting bigger and bigger and bigger and they say, well, we'll just pay out more capital. And then you're getting, you're getting a 12% dividend yield and all of a sudden that's a big deal because that's a 12% return in your hand. Plus you get the, you know, the real growth from dividends as well. And, and so that's when they re rate is when the, the corporates start changing their behavior.
- [52:31]
B
Well, first you get an A because you've now related to water to all six questions. Yes, I was wondering if you would make it, make it to the end. But you now have been able to successfully do that. So you get to be an a podcast guest for that. How do you think about China? I mean, I think, I think China and Taiwan are, are very close to half maybe of emerging market indexes. You can correct me on that. But like how do you think about China and Taiwan relative to the rest.
- [52:52]
A
Of the emerging market? I think you need to own EM active, supposed to be very easy to go passive in the U.S. you know, it's a single market. You kind of understand the politics and you understand economics. You just saw one currency. EM is complex. There's a mix of currency is a mix of different geopolitical regimes. It's mix of different regulatory Regimes, massive differences in corporate governance framework, risk. And so I'd say at em, you shouldn't just run a passive. I'm not a big passive fan, as you might have already noticed, but I certainly wouldn't do it in em.
- [53:35]
B
Do you have any views on China? It's something we've talked about a lot in the podcast. Just we've had some China, huge China bulls on recently. You know, we've had other people say you just can't invest in there because of all, all the dynamics. Like, do you have any views on China given that it's such a huge part of the emerging market?
- [53:48]
A
I think you know that my overriding for you.
- [53:52]
Well, there's a conflict, isn't there? And I think the people who are very, would say they're very bullish is they just look at the companies and the companies are very good and there's an entrepreneurial culture and you, you can buy a lot of things, low valuations. We own a few, a few Chinese businesses and they do look like great value. And then there's people who are looking more from the top down, who are much more cautious. So it really depends on your lens, as it normally does. My overriding fear, because I acknowledge all of the bottom up attractions of China, my overriding fear is that if you look at the history of when two superpowers have clashed and there's a growing one challenging an existing one, it doesn't tend to end well. And not only that, if you look at the ideologies of China and the US they're very, very different, very, very different, apart from this kind of element of entrepreneurialism, pseudo capitalism that you see at the corporate level and very, very different ways of thinking and governing. And I think it's very hard for those two countries to not clash over the next 10 years. And it's a big question is then what, what do you do about that? And my view, like, you know, a lot of other things is everything's a range of outcomes and so you just need to, it's okay to own some, but just don't, don't go overboard and recognize that there's tail risk.
- [55:31]
B
This is going to be great. This has been great. I'm going to ask our standing closing questions. Before I do, I just remind you, do not have to use water so you get 100% score for the six. You do not have to go into the final two and work water again. But our first question we ask is what's one thing you believe about investing that you think the Majority of your peers would disagree?
- [55:50]
A
Well, there's one phrase that just bugs me to death and almost all of my peers would use it and they say something along the lines of even the best investors are right only 60% of the time. You've heard must have heard that? Oh, yeah, many times. Okay, so I vehemently disagree. Okay, So I think, and some of the very best investors say this now it might be semantics, and I'm being very pedantic here, but investors often forget that making a great decision and experiencing a great outcome are quite distinct. Right. So poker players understand this very well because they play multiple hands in a single session and they understand that when they've made it, sometimes they make a decision, they get a terrible outcome, sometimes they make a terrible decision and maybe they've got a great outcome. But investors forget this all the time. Again, I think it's a function of investors being pummeled by their clients for poor short term performance. If they say, oh, but I made the right decision, that tend to not go down very well, but you know, it should go down well and plans should recognize that. That is a, you know, the amount of noise of volatility and luck, frankly, in the investment industry. Much, much higher than any in any poker game, which is controversial, but I 100% believe that. So if you go back to 60. Right. 60% of the time, the correct phrase should be that the best investors have a 60% success ratio. That is 60% of their holdings go on to experience winning outcomes. Okay. Now we've actually measured the percentage of good decisions that you need to make in order to get to that 60% outcome. And the answer's 90% or 95%. So you need to make great decisions 90% of the time or 95% of the time to have a measly 60% winner ratio. So there's very little roof error. And I think that's underappreciated. This is a really, really tough, tough business.
- [57:46]
B
That was great because we often get answers to this, that maybe I say, oh, you know, most people probably wouldn't disagree with you on that. But that's something I've said myself.
- [57:53]
You only have to be right 34 of the time. So it's perfect when you're disagreeing with something I've said myself. And our final closing question is based on your experience in markets, if you could teach one lesson to the average investor, both.
- [58:05]
A
I mean, I think going back to the water. Sorry, I don't mind the warning.
- [58:11]
Going back to the speech rather, that Cruise speech. The humility run through. So humility, I think, is your greatest ally. It's funny.
- [58:23]
I think the best people in this industry are raising large aum are typically the managers that are most definitive and certain of their views. So it's the same as with politics, especially today, the j But to be definitive and certain about pretty much anything in a highly stochastic and uncertain world I think is just crazy. It's the height of folly. So if a manager loses confidence, you should run a mile instead. You should look for, definitely should look for knowledge, right? But you look for knowledge with a high dose of humility and uncertainty. So this is wholly unnatural because we like people who exude confidence. But you want the opposite in a money manager, right? You want the one that says I'm not sure, okay, as they're going to act in a way that reflects the uncertain outcomes that we all face in investment and in life. So humility would be my advice for investors. Whether you're looking for managers or you're investing yourself.
- [59:16]
B
It's interesting because when you were saying that, I was thinking we've had some managers who invest in maybe innovative tech companies in the US that have those characteristics that had incredibly high confidence. And when you couple that with really good short term performance, you can get huge assets. But that can also end very badly for the people who invest.
- [59:31]
A
It is absolutely fascinating.
- [59:34]
B
Well, Graham, thank you so much for joining us. This has been awesome. If anybody wants to find out more about your papers, they can go to orbis.com, both papers we reference are there. Thank you for joining us. This has been great and really appreciate your time.
- [59:43]
A
Thank you tech. It was wonderful.
- [59:44]
B
Thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform on YouTube. You can also follow all the podcasts in the Excess Returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.