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Excess Returns
We Asked a $1 Billion Quant Manager Why Concentration Isn't a Warning — and Small Caps Aren't Dead
00:57:25
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- [00:01]
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- [00:56]
Matt Zenz
If it didn't feel bad, if it wasn't painful to keep holding it, you wouldn't get rewarded with higher returns. A lot of these AI companies, Google, Microsoft, et cetera, they are investing a lot into CapEx, into these data centers, et cetera. But as a percentage of their overall company, it's actually not that much. At the time it always feels like these companies are going to take over the world and then 10 years later it's a different 10 companies. And in hindsight it makes perfect sense as to why these ones are now the biggest versus those. There's lots of companies that could have IPO'd as small caps at the same time. SpaceX could have that went to zero. Think like WeWork, right, like WeWork was an extremely popular company everybody was talking about. Took a while before it was going to think about IPOing and it went bankrupt.
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Jack Forehand
Welcome to Excess Returns. I'm Jack Forehand and today I'm excited
- [01:46]
Matt Zenz
to be joined by Matt Zenz.
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Jack Forehand
Matt is the Founder and Chief Investment Officer of Longview Research Partners and also the manager of the Longview Advantage ETF and the newly launched Longview Advantage Fixed Income etf. Matt welcome to Excess Returns.
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Matt Zenz
Hey Jack, how are you doing?
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Jack Forehand
Good. It's great to have you and I'm kind of excited because you are an evidence based investor, which is what I've tried to be my whole career as well. And I feel like we might be in a world right now where people might need a little bit of that. I don't know if you think that's an exaggeration, but I feel like Evidence based investing might be something that's good
- [02:15]
Matt Zenz
for everybody right now. Yeah, I mean, personally, in my investment philosophy, I think it's what everybody should be doing all of the time. But yeah, there are certainly times when maybe people need a reminder, need to dive into it a little bit more. And so, you know, with social media now and everybody touting these, you know, levered products or the new IPOs that are coming out, and people get real excited about these types of things. Sometimes it's good to kind of go back to basics and terms of what drives returns.
- [02:43]
Jack Forehand
Yeah, you're definitely right. I mean, we should always be evidence based investors. But during these, I don't want to say bubble, but like bubble, like periods, people tend to be a little more detached maybe from the evidence than they. Than they normally are.
- [02:54]
Matt Zenz
Yeah, exactly. Yeah. They live in the moment and kind of forget about what's happened in the past.
- [03:00]
Jack Forehand
I'm just curious, before we start, do you like going through these periods? You've looked at evidence through 100 years of history in terms of how things happen. When you go through these periods, do you feel differently in the period than looking at the evidence? It's something I've experienced a lot in my career. You look at the data and you're like, all right, value investing can struggle. And you're like, oh, look at the chart though. It came right back up. But then you go through it and you're like, this is a disaster. Or you go through these bubble periods and it's like, oh, I know if I went through the 1990s, I would have been like, no problem. I understand. The evidence will take over again. But then you're in it and you're like, AI will change the world forever. Do you see that disconnect between being in the real period and also looking at the evidence?
- [03:40]
Matt Zenz
Yeah, I mean, I try to divorce myself that as much as possible, but when we talk to clients and prospects and those types of things, it is almost impossible to divorce yourself. From what you're hearing today to the history, like, there's so many people who are just like, oh, yeah, 2008. Yeah, I would have bought back in, like I wrote those returns, no problem. But you know that 20% drop in the first couple weeks of COVID like they were freaking out or, you know, any type of small drop. And so. And at the time it always feels worse, but that is ultimately what drives the return. If it didn't feel bad, if it wasn't painful to keep holding it, you wouldn't get rewarded with Higher returns. And so it's, it's that discomfort is what actually drives the return that you get if you're actually able to stick with it for the long term.
- [04:26]
Jack Forehand
Yeah, I don't know if it was Corey Hofstein, but someone said no pain, no premium. And I think that's a great, I think that's a great saying to like, think about, you know, things like that and how they work over the long term.
- [04:34]
Matt Zenz
Yeah, yeah, no, I, I, I totally agree with, yeah, with that, with that assessment. It's, you get paid for risk. Right. And if you're willing to bear risk, and risks can be defined as, you know, feeling uncomfortable, not being able to meet your goals, downside, you know, returns. And so that's, you got to balance those. And if you're willing to stick with it, then you're going to get reward with return.
- [04:57]
Jack Forehand
So I'm not going to ask you about the overall market, but I do want to, like, have you help me put it in context because we are in a period that some people call bubble. Like we're in a period where we're seeing, I don't know if it's unprecedented concentration, but we're certainly seeing high concentration in the major indexes. I'm just wondering, as someone who's looked at evidence, who's looked at 100 years, like, how do you think about this period in general?
- [05:16]
Matt Zenz
Yeah, I mean, typically, I think, like, is it a bubble type question is usually the wrong starting point. A lot of people, they think about a story like, oh, market's getting more concentrated and they hunt for data to support that. And as an evidence based investor, we try to stay away from that. We start, we try to start with prices. And so right now, what is the market telling you with the prices? It's saying there are a handful of companies that are extremely valuable. The market thinks they're valuable because they think they're going to deliver a lot of profits in the future. That might happen, it might not. And you know, for us, we think about market concentration, we just think it really means there's really an extra value on being diversified. Diversification is especially valuable during these periods of time. And so we try to encourage people to think and be careful about, you know, just because things have done well recently doesn't mean they're going to continue to do well. But it also doesn't mean that just because markets are concentrated in a handful of names, that means the market's going to do worse. You have to treat it, you have to try to, you know, remain diversified. And there's lots of ways to kind of get that diversification out there.
- [06:22]
Jack Forehand
And I've always wondered if that bubble question is useful because a lot of people like to say, are we or not in a bubble? But then when you get to the question of like, what do I do about it? It becomes much more challenging to try to figure that part of it out.
- [06:32]
Matt Zenz
Yeah, I mean, bubbles are super easy to identify in hindsight. Right. But. But, you know, it's kind of. But really hard to know while you're in it. Right. The reason why this could, you know, these markets are frothy, that these AI companies are doing really well is because maybe they will deliver on those expectations, maybe they won't. You know, for us, it's not so much about thinking about things in terms of number of companies. What we think about in terms of is economic engines. So if you look at like The S&P 500, the top 10 names are something like 40%, but most of those names are in IT companies or AI companies. And so it's not so much that it's a number of names thing hit. It's what is the economic exposure you're exposed to. And if you're only invested in the S&P 500, your main allocation is really to information technology IT in the U.S. now, if you're a global investor, you add us small caps, you add international stocks. You just went from your top 10 holdings being 40% cut in half down to about 22, 23%. That's a huge difference. And so when we make portfolios and we think about investing, we think about it globally. And, and then that market concentration you see at the top in the US is less important. And I also think, we don't also think about individual names. Like, just think if Nvidia acquired Tesla and Exxon, that company would be even bigger than it is today. It might be 10% of the market, but the underlying economic exposures are the same as if you held the three companies separately. So just because companies are acquiring other ones or growing, what really matters is what is the underlying economic drivers behind that. Are there other companies with similar economic drivers? If something bad happens in that piece, that that sort of economic structure, will that have a negative impact? And that's why we want to be as diversified as possible. Invest globally, invest in small caps so that you're not kind of concentrated in maybe that one IT AI bet.
- [08:33]
Jack Forehand
And that's what I like about what you do, is you guys, and correct me if I'm wrong, but you guys kind of start with the market and then you make adjustments from there. And I think a lot of the value investors, me included, have kind of been shaking our fist at the mag 7 for like these past however many decades while they just continued outperforming and using our ratios and saying that doesn't make any sense. But like, if you start with the market and then adjust from there, you understand, like these companies, if you look at their fundamentals a decade ago and you look at them now, they've gotten a lot better. That doesn't say they're not expensive now. It just means these companies have been growing their businesses a lot. And that's partially, at least represents why they're such a big part of the market.
- [09:03]
Matt Zenz
Yeah, exactly. Yeah, they've done well, and so they've performed well for two reasons. One is they've been really profitable, but they. The reason why their values are so high today is because people expect them to continue to be profitable and continue to have really high profit margins. And so that's all in the price today. And investors who invested in those companies 10 years ago got the benefit of that. What we don't know is what's going to happen the next 10 years. If they continue to exceed expectations, then those investors will be very happy and continue to outperform. If they don't, then they won't. But ultimately all of the kind of buzz around those companies is already factored into the price. And so what you would need, if you wanted to continue to hold those, is they have to do better than people expect.
- [09:48]
Jack Forehand
So you don't see anything in market concentration in and of itself that's a concern for the market?
- [09:53]
Matt Zenz
No. And, and it's it. And it, you know, depends what you mean by concentration against individual names versus sort of sectors, but not really. There are many markets that have very few names. There are countries with one stock in them with 10 stocks in them, and those companies have delivered high returns. When we look at sort of the number of names in a particular market or the amount that the top names make up in any particular market, there's no evidence that says higher concentrated markets tend to have lower returns or higher returns. What we think is the best course of action is to limit your volatility, which would be be as diversified as possible. But concentration itself doesn't mean higher or lower returns.
- [10:36]
Jack Forehand
I'm going to guess you don't concern yourself with overall market valuation too much. But I am just wondering, is that accurate?
- [10:42]
Matt Zenz
First of all, it is in terms of. So I kind of wear two hats. So I work at, you know, I'm the chief vest officer at Long Research Partners, which you mentioned we, which is an asset manager, but on the side we have a sister firm that's an RIA where we manage money for individual clients. That's where this thinking about the valuation of the market matters to us. And that's because higher valuations tend to mean over the long term, lower returns doesn't mean negative returns. The, the market is always priced to deliver a positive return. If it wasn't, no one would buy it at that price and the price would come down. And so if it's always a positive return, I want to be invested in it. Now what it tells me though is what I should expect for financial planning. We use it as a financial planning tool. If the market's at really high valuations, it means returns might be lower than the historical average. And so we need to factor that into financial plans. If valuations are low, it might mean that future returns are higher than they have been in the past. So it doesn't impact what we invest in, but it does impact how we plan for the future.
- [11:51]
Jack Forehand
That actually leads perfectly into my next question because as you think about those expected returns, you know, you have one camp of people that says, you know, there's a long term average in terms of the market valuation and we're obviously way, way above that, you know, and they say we're going to revert back to that over time, which would affect those expected returns. And you have other people who say, yes, the market is expensive now, but we would expect, you know, valuations over time to go up to for a lot of different reasons. I mean the mix of the market right now would be one, I mean, we've got higher margin businesses leading the market. But like, what do you think about that? I mean, do you, do you have any thoughts on this idea of like if the market should be reverting back to like its long run average or if things have changed in the world and we're in a better world and maybe higher valuations are justified in general. Maybe they're not the ones we have now, but at least in general.
- [12:33]
Matt Zenz
Yeah. So there is some data around mean reversion. Right. So you know, price to earnings ratios are really high right now. But there are two ways for price to earnings ratios to go back to historical averages. One is prices to go down. Right. If you want your PE ratio to shrink, you have that prices go down or earnings go up. And so PE ratios could shrink without any impact on price, your return could be the exact same it has historically, but earnings can just go up a lot and then your PE ratio comes back down to normal levels or prices could go down. And so in different times in the past, different things have, have happened in terms of sometimes prices go down, sometimes earnings go up. So ultimately, when it comes to investing, we don't know what the, what the driver is going to be. We use valuations kind of, as you mentioned in, or as I mentioned before in planning, but ultimately we don't use it to inform sort of future in terms of like what companies we're going to invest in. But just because the market as a whole might revert from a price to earnings perspective doesn't mean that individual companies all have the same price to earnings. There's a wide spread in individual companies, and that's where you can add value when it comes to investing is you can, you know, even if the market has an average PE of 25 and the historical average is 18, and we think it's going to revert, well, not every company has a PE of 25. Some have lower than 18, some have higher than 25. And if you can focus on the companies with lower valuations, that implies higher returns for those individual stocks.
- [14:09]
Jack Forehand
Yeah, that gets to the idea of value spreads, which we are seeing are still, I mean, maybe not unprecedentedly wide right now, but still pretty wide between the most expensive companies and the cheapest companies.
- [14:17]
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- [14:18]
Matt Zenz
Yes. They're like something in the 85th 90th percentile right now. So they're not as crazy as they were, let's say, two years ago, but they are, they are still wide. Wide valuation spreads typically mean larger value premiums, which is what we've seen over the last year. That's come, that's come true. But again, you never know. That's, you know, over many decades, that's what tends to happen. But over any individual year, any short time frame, we, you know, we don't really know. But you should expect value to do a little bit better than growth, better than it has historically, because valuation spreads are so wide. But things can always get, always get worse, always go in the other direction.
- [14:57]
Jack Forehand
I want to ask you about this AI CapEx, but not from the perspective we've been talking about. It was a lot of other investors and we've been talking about the idea of people who studied railroads and past booms and things like that. But one of the unique things about you is you've started factor investing for a long time and there's definitely Some interesting research in factor investing about what happens when firms spend a lot of money on Capex historically. So I'm wondering if you could share that.
- [15:17]
Matt Zenz
Yeah, so this gets to kind of investment, right? And if you just go back to the valuation equation where your return is the profits that the company has discounted to today, but those profits can either be given back to you as an investor or invested back into the company. And if they're invested back into the company, they're not going to you, which can impact your return. You're not getting that return. And so what the research has shown is that companies that do a ton of investment tend to have lower returns in the future. Now what I mean by a lot of investment is we're talking 70 to 100% growth in assets, meaning they're like doubling the size of their company because of the amount of investment that they're doing.
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- [17:20]
Matt Zenz
A lot of these AI companies, Google, Microsoft, etc, they are investing a lot into Capex, into these data centers, etc. But as a percentage of their overall company, it's actually not that much. And so when we think about these Capex investments, we do avoid companies that invest a lot. But a lot is actually more than you Think. And so these companies that are doing these data center type things actually aren't hitting that threshold of investing enough that we would be worried from an expected return perspective. And so there's really not much that the data says when it comes to these types of companies investing in, you know, the capex that they're doing now in data centers, et cetera. It could work out, it could not. There's not enough data to say one way or another if that's something that you should dive into more or avoid.
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Jack Forehand
That's such an important point because you have to think about it relative to the size of the companies that are doing it. And people talk about massive, they throw out massive numbers of this massive amount of capex. But we also have to keep in mind these are massive companies doing the massive capex.
- [18:21]
Matt Zenz
Yeah, they're trillion dollar companies and if they do a couple tens of billions of dollars, that's not a huge percentage of their overall company.
- [18:32]
Jack Forehand
I want to talk about how you think about some of these things from an investment standpoint. But first, this is probably a good time to talk about your strategy in general. So with ebi, can you talk about like how you manage the portfolio, how your investment strategy works?
- [18:43]
Matt Zenz
Yeah. So you know, for, for us, you mentioned before, you know, we're factor investors. When most people think about factor investing, they think about the known five factor model, the known premiums, things like size, value, profitability. I think we think about things a little bit differently. We think about things in terms of discount rates. So any company, if you want to know the value of it, what you do is you take what you think the future cash flows are going to be and you discount them to today. That discount rate is your expected return. It's the dividend discount model, valuation model. And so what we're trying to do in EBI is, is simply find the companies with the highest discount rates. Those are the companies that investors are demanding the highest return for. And if you invest a little bit more in those companies, you're on expectation, should have higher returns. Now the typical factors that people think about, value, profitability, size. Those are great proxies for that. For things that have high, higher discount rates, higher expected returns. And so we use those in order as, you know, clues to find the companies that have higher discount rates. So you know, for example, you have two companies that have the same price, but one has much higher profits. Well, that company has a higher expected return. You're paying the same thing, but you expect to receive more with the higher profits. That must mean those profits are discounted at a higher rate. It means investors are demanding a higher return for that investment. The same can be true on the flip side, if you have two companies that have the same level of profits, but ones at a much cheaper price, it must mean that investors are discounting those profits by more. It means the expected return is higher. And so, you know, price future profits. Those are things like value, profitability. You can use those metrics to get you to that level. And so ultimately that's what we're doing in this fund, is doing it in a low cost, diversified way. We hold thousands of companies from large to small across the US in a low cost way, but we're just tilting a little bit more to the ones with higher discount rates. And we're doing it in a very nimble way. We keep, you know, we're not a huge trillion dollar asset manager. And so that keeps us a lot more nimble, allows us to move much more quickly as prices change every single day.
- [21:10]
Jack Forehand
Can you talk about the logic for starting with the market and then adjusting? Because I guess one way you could run this is you could say like, give me the highest, the 50 companies with the highest expected return or something. I'm just going to buy those. But you've decided to start with the market and then make adjustments around that. Can you explain that logic?
- [21:22]
Matt Zenz
Yeah. So it, it all depends on how much risk you're willing to take. Right. So there is a single company out there that has the highest expected return. When you look at these metrics, the investors out there are discounting the future cash flows at the highest possible rate, meaning it's the riskiest company, but it has the highest expected return. You could put all of your money in that one company, but there's no guarantee. Right. Risks happen and maybe you lose it all. And so then you could say, well, I'll do two companies or I'll do five, or I'll do 50, or you know, however many you want to do. And so it's just a question of how much risk you're willing to take and what do you want your overall portfolio to look like. And so we think the market is a great place to start. You start with market cap weights. That is what the market, that's how much the market values every company. We're going to start there. We're only going to deviate if we have a good reason. A good reason is we think certain companies the market thinks have a higher expected return, maybe because they're riskier. So we're Going to put a little bit more weight there and a little bit less weight in other companies and we could have done just 50. But then we're taking a lot of risk. If those 50 just happen to be a bad draw or you go through a five to ten year period where the risks materialized and those companies really took a big hit, well, now your whole financial plan could be destroyed. And so it's really about balancing risk and reward. And we think within our fund ebi, we've done that, we've got the whole market. So tracking error should be in the 3 to 6% range and we expect to outperform due to those tilts that we talked about.
- [22:56]
Jack Forehand
Yeah, and I think behavior would probably be a big part of that as well. I remember when I was early in my factor career, I decided I'm going to be a hero. I'm going to run these 20 stock focused factor models. And then as soon as that goes bad, you realize investors aren't sticking with those things when things go south on you. So I think this is a much better approach behaviorally.
- [23:11]
Matt Zenz
No, we don't hear it too much now because value has done well over the last year. But know, a year ago for, you know, 15 years, people are talking about values dead. And, and so, you know, that was a 15 year period where value underperformed. If you were only in the 50 most value companies, you may have underperformed by 5,6% annually for a decade. You know, that means you have half the amount of money you otherwise would have. You know, you know, a lot of people just compare themselves to their neighbor. You know, your neighbor's buying new cars, getting a new house and you're like, what the heck are you going to stick with that? I don't know. A lot of people can't. And so you have to see, like, what can you stick with from a behavioral perspective? And so leaning in a little bit, maybe you can stick with it through the bad times. Whereas leaning in a lot, maybe you get out and then you never capture the benefit.
- [23:57]
Jack Forehand
Does that expect a return framework allow you to look at an opportunity set at different times? Like for instance, I would bet like the opportunity set in 2009 was a lot better than it was in 1999, just because in general there's more companies that are cheaper or might look more attractive fundamentally, does it, is that the wrong way to look at it or does that like give you an opportunity to say, like, we have better opportunities one time than another?
- [24:16]
Matt Zenz
Yeah, so I think there's two different ways to think about the opportunity, one is the entire market. Right. So when the entire market is at super high valuations or super low valuations like 1999 or 2008, that tells you what the opportunity in the market as a whole is. Again, we always expect the market to have a positive return. But in 1999, maybe you thought the market, the future return is holding only going to be 6% annualized, whereas in 2008, when you're looking at it, it's 10% annualized just because of where valuations are today. And so 2008 looked like a better time to get in. It was also because it was riskier. Right. Like getting in at 2008, you're getting a higher future return because you're taking
- [24:55]
Jack Forehand
a lot of risk.
- [24:55]
Matt Zenz
Things could always get worse. We didn't know that kind of what the Fed was going to do and that kind of was going to solve the problem. Then that's kind of the first level. Then the second level is within the market, what is the spread of things. And so in 2008, kind of everything was depressed. So there wasn't a large spread between the growth names and the value names. They all kind of look similar. And so you didn't have as much opportunity there from a value versus growth perspective, but you did have a big opportunity in terms of the market as a whole. Then you look at 1999, the spread between growth companies and value was huge, similar to what it is today. And so while the overall market may not have as big of an opportunity, individual names within the market have more opportunity and there's more lower valuation names that you can invest in that have higher expected return. And you know, we did see that in 2000-2004, where value crushed it. We have no idea what's going to happen over the next four years. But we're seeing similarly high market valuations and similarly high valuation spreads to what we saw in 1999. But that's just, that's an anecdote. That's one time in history. And we don't base anything we do off of one period in history.
- [26:07]
Jack Forehand
But it's interesting to hear because this is a completely different way to look at, like comparing 1999 to now than most people look at. You know, most people are looking at what was going on with the tech and the environment and all that. And you, you can look with actual numbers, with spreads, and kind of say, here, here's how these two periods compare to each other.
- [26:21]
Matt Zenz
Yeah, yeah. People try to compare it like, oh, like The Internet was this massive technology. Everybody was investing into it. Now we have AI, Those are the same. We tend not to think about it that way. We look at prices and profits. You know, what are the profits of these companies? What are the prices telling us? What does that mean about the return investors are demanding for different stocks? And that tells us how we should approach investing in that environment.
- [26:45]
Jack Forehand
Speaking of tech companies that have sort of taken over the market here, how do you think about valuation in the world we live in today? Some people argue some of the things like price to book that we've used for a long time are no longer really applicable. Like, a lot of these companies have most of their value and intangible assets. Like, do you think about valuation differently because of the types of companies we have today than maybe in the past?
- [27:03]
Matt Zenz
Yeah. So we.
- [27:05]
Jack Forehand
We don't.
- [27:05]
Matt Zenz
And the reason is because it's really hard to do. So if you think about intangibles, a lot of people think the value of companies now is more in intangible assets. So things like, you know, you do a bunch of research, develop a new product and that has value to it, or you have a patent or things like that. And there's two different types of intangibles. There's externally acquired and internally developed. So if I'm a company and I go and buy another company, whatever market price I pay for that company, you can add up all of the assets and liabilities and you get this net asset number. Whatever I pay over that, that is the intangible value. Right? Like I take all the factories, add all those up, all the cash, it's worth $10, and I buy it for 20. That means there was some intangible value of $10 that goes on my balance sheet now because I bought that company. There are some firms that want to remove that from the book value, saying, that's an intangible asset. We shouldn't be accounting for that because that's not part of the company. Really. I think that that's kind of silly. You're removing information. The market determined what the price was of that intangible asset. It was purchased on market. And that has value. And you should factor that into your valuation of any company. So that's one side. Then there's the internally developed. I'm a company, I've been a ton of R and D developed, all, you know, developed AI, you know, as this great capacity. And that's why my company is valued so highly. You want to capture that, like, what is the value of that intangible asset? Well, it's really, really hard to determine. There are a lot of people who have tried in different ways and there just isn't anything that's repeatable or reliable in determining that. So one test you could do is you could say, well, a lot of people try to capitalize R and D right. Every year. You've spent a lot of money on R and D for the last decade and that has value. Right. It's not just R and D goes out the window. That has some value. That's an asset. And we could capitalize that every year. Whatever you spent in R and D, let's pretend that's an asset, make that intangible and add it. And then companies do that and they get acquired. You can go back and see, okay, they were acquired, they were acquired for some price. How much was that intangible asset actually worth when the market bought them? And compare it to your research results of capitalizing the R and D. And what you find is there's no relation that by capitalizing the historical R and D told you nothing about what that intangible value is actually worth in the future. And so I'd love to be able to capture the intangible value. I just, there hasn't been a good, repeatable, reliable way to do that. And so we think it's better just not to touch it than try to do something that creates noise and provides no value.
- [29:58]
Jack Forehand
Yeah, to your point, I think if we're going to figure that out eventually it's going to be like some more advanced methods. Because like, if I wanted to find the value of Google's brand or Google's search engine, like I couldn't have adjusted their financial statements in any way that would have gotten me to that value.
- [30:10]
Matt Zenz
Right. I wouldn't know how to do that. And you know, there are a lot of people trying to do that with different AI models and that kind of stuff. I'm not sure how they would do that through that either. And you have a huge, like data mining and short sample size problem is that this hasn't been around for very long. The data hasn't been around for very long. Markets are extremely noisy and so it's really hard to draw any conclusions off of five or 10 years of data. You need 100 years of data in 50 countries before you can really say anything that meaningful about what truly drives returns.
- [30:45]
Jack Forehand
Given that you start with the index in the construction of your portfolio, I thought it'd be interesting just to ask you about some of the stuff that's going on at the index level right now because we just had a major IPO with SpaceX. We've got some other ones coming and the indexes have been all over the place trying to figure out, like, what do we do with this? Do we break our rules? Do we add it right away? And I could see, I could see two arguments to it. I could see one side. This has not typically gone well for the indexes when they've added these types of companies. But on the other side, I could see they're trying to represent the market. And some of these will be very big positions. Obviously SpaceX only has a small float right now, but these will be pretty big companies. And you could make the argument you got to add them. I'm just wondering if you have any thoughts around that.
- [31:18]
Matt Zenz
Yeah, yeah. I mean, indices have, it's tough. They have a dual mandate. Right. So they started out purely as a benchmark. That was what they were meant to do. Let me just give you the performance of the market and under that framework, they should add it. It's part of the market. But indices have changed, and in a good way in that they now are more for investment and people are actually investing in these indices. And I think a lot of the reason is because typical active managers have underperformed and people are better off in just indices than a typical active portfolio. And so now these indices need to think about, well, I need this thing to be investable. I need to make this such that people want to buy it on the other end. And so that changes their dynamic. And so different indices are going to come on different sides of that based on the feedback they get from their end. People who subscribe to that index, some of them are adding it sooner, some of them are not. To your point, it hasn't fared well. And this is where being flexible, not being so rigid in terms of having to follow an index, allows you to take advantage of these types of things. So typically IPOs tend to underperform in their first year. That's part of that reason is due to the fact that most companies that IPO tend to have really bad valuation characteristics. Right. We already said that, like valuation matters, the discount rate matters. They tend to have really low discount rates, meaning low expected returns. And so they tend to have, yeah, lower. So we ideally would want to avoid it. That's why they don't have great returns in their first year. And so what you want for markets to work is you want price discovery. That often takes some time for markets to understand what this company is how they want to value it. When companies have low free flow, when they have lockups that restrict supply, that inhibits price discovery. And so generally we try to wait until those lockups end around six months before we would add a security to our universe and start investing in it. Indices don't, you know, have to balance different objectives, giving people exposure to the market, but then also making it investable. And they're going to fall on different sides. When you have a flexible approach, you can make the decision that's in the best interest of highest expected return. And in most cases that's waiting six months and then adding it to your portfolio just like it would be any other stock. Right now SpaceX looks really bad from a valuation perspective. It's from a, you know, valuation and profitability perspective. It's not something we would want a lot of weight in.
- [33:54]
Jack Forehand
To your point too, there's so many things like when an IPO comes out, so many mechanical flows that are going on that have nothing to do with the fundamentals of the company. So I can understand the idea of like, let's wait this out a little bit. Like this index is adding it. These people are like, let that play out a little bit and then maybe add it after that.
- [34:09]
Matt Zenz
Yeah, I mean, only 5% of the shares are actually trading right now, and we expect something like 30 depending on what metrics they hit in terms of price over the next six months. But another like 30% to, to kind of release itself from the lockup over the next six months. And so you're gonna have a lot of people probably selling some of their shares. And so in our view is let's let those mechanics play out after that six month period of time, then we'll look to adding it to the portfolio.
- [34:35]
Jack Forehand
Yeah, that's something people miss a lot too because of these free float adjustments. Like SpaceX would not, even if it went in the s and P500 tomorrow, it would not go in nearly at its market cap weight.
- [34:43]
Matt Zenz
It would go in way, way, way less than that.
- [34:45]
Jack Forehand
Because there's only a small float out there right now.
- [34:48]
Matt Zenz
Correct. But some of these indices are adjusting their float rules. Right.
- [34:52]
Jack Forehand
I saw that the NASDAQ was doing
- [34:53]
Matt Zenz
that company only has 5% float. You want to weight it at 5% of the total company value such that your weight matches what's actually available. Well, some of these indices aren't doing that. They're actually putting the weight at something like three or four times that. And so that creates a problem because now you're demanding Three to four times the liquidity of this actual name. And that can have some negative consequences in terms of price and that type of stuff. So yeah, you got to be, you got to be careful. Implementation is so important and these indices need to be careful in terms of how they're doing it. I mean they don't necessarily care. But the end investors in those indices are going to feel the pain of that.
- [35:33]
Sam's Club Advertiser
Yeah.
- [35:34]
Jack Forehand
And on that issue of implementation, this is something we talked to you a lot about last time you were on. That's one of your things that long view is the most important to you in terms of differentiating yourself from maybe some of the larger providers and have to move massive amounts of money around is your ability to implement properly. So I'm just wondering if you have any, first of all, can you explain what you do? And then you probably have some data now since last time we were on in terms of how that's going. So I'm wonder if you can talk about that.
- [35:53]
Matt Zenz
Yeah, yeah. So you know, when you think about this, when we, when we think about kind of comparing any two strategies, things like that, we, we think of the three Ps, price, premiums and process. So price, what are you paying for the strategy premiums? What research do you have that you think stock A is better than stock B and then C or then process, how do you do it day to day? And if you compare an evidence based factor strategy to an index, an index wins on price, right? They give really low prices. But typical evidence based strategies win on premiums in process, right? They're going to go after companies with higher expected returns. We expect that to play out in the long run and then they're going to have the flexibility that indices don't have around process where you can trade every day. When we compare ourselves to some of the larger evidence based firms out there, you know, ones that have a trillion or more in assets, we have the same price as them, we go after the same premiums, right? We're all looking at the same research. We all define the premiums roughly in the same way, we all pursue the same ones. The difference is in process, how we actually do it. And if you're a trillion dollar manager, you might own 5 to 10% of every small value company out there. Well, if prices change every day, if you no longer want to hold that name, you now need to sell 5% of the outstanding shares.
- [37:16]
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- [37:47]
Matt Zenz
Whereas if you're a smaller manager, you might need to sell 0.05% of the outstanding shares. And for us, it takes a day to buy or sell a company. For these larger managers, it takes them a year. Well, that's going to impact returns. If you believe prices mean anything and prices change and that reflects your future return, you want to be able to move as quickly as possible and these larger managers just can't do that now. It's still better than indexing. Yeah, that. But you know, you don't want to be trading all of your volume in one day. But the fact that you have to wait a year to slowly get in or out of the name, that's ultimately going to lower and impact returns. And we've seen that in our first year. So we've been, we've been running our fund for about a year and a half and when we compare ourselves to the large, you know, trillion dollar evidence based investors out there, you know, we've outperformed a similar type portfolio by about 2 1/2% over the first year and a half. That's meaningful. You know, again we have, we're going after the exact same premiums, define them in the same way. The difference is just in process and how we do it. And we've been able to pick up an extra 2 plus percent annually so far in the first year and a half just by caring about implementation.
- [38:59]
Jack Forehand
On this issue of execution and flows, do you have any thoughts? One of the things we've talked about a lot in the podcast, I don't know if you're familiar with Mike Green's work, but this idea that we've got a lot of money flowing into passive investing these days, for most 401ks, that's the default option that leads to significant flows into the market which don't really care about the fundamentals. They're just kind of flowing into the market. And you know, Mike has argued that that has in terms of the relative pricing of stocks, that can have an impact because maybe Nvidia's liquidity doesn't scale as much as its market cap does. And so maybe there's this pressure on these biggest stocks over time that's like forcing them up relative to other stocks. I'm just wondering, do you have any thoughts on that? I know you've looked at implementation a lot. Do you have any thoughts on like that and whether you think that's accurate?
- [39:38]
Matt Zenz
Yeah, so I think what Mike talks about is a little bit different than what I think the average person talks about. So the average person thinks, okay, money is going into indices, it's pushing up the biggest companies larger. Right. That's just not understanding how indices work. Right. Indices, market cap weight, meaning the same amount, proportional amount is going into each company. And so they're not pushing up prices of large companies over small companies anymore. Now, in fairness to Mike's argument, he doesn't say that. He says, well, you have to look at price elasticity, that the same amount of dollars is going in proportionally, but if certain companies are have more of an elastic or inelastic price, that's going to impact different companies more or less. And I think that may be true. It's really hard to know what the elasticity of price is for each individual company. That probably changes throughout time. And so, and it's unclear as to like on the margin how large this impact is. I also, as an investor don't know what you necessarily do about that in terms of how you would benefit from that in your processes. The way I think about it is, you know, people invest. What I care about is price discovery is information getting into prices and information does get into prices via indices. Just because you buy an index doesn't mean you're not adding value to the price of that of any individual stock because people use indices in all sorts of ways. I can express my opinion of investing in the US versus International by buying US index funds. I can express my view of just the market in general by shifting money from private equity to global stock. You know, global index funds. I could express my want to do small value funds through a small value index. And so people can express their opinions all the time through index funds. And that's what you see. These index funds have tons of volume traded. It's not from buy and hold investors, it's from people speculating. And so what we care about is, yeah, I mentioned is price discovery. We think that's still happening. And you can see that in individual stocks. We don't see the correlation between stocks increasing. It's not like every stock in The S&P 500 moves the same, they all move differently. When news comes out, say a company gets acquired, we see the stock price immediately jump. When earnings announcements come out, we see the stock price change. And so price discovery is still happening. That's what investors should care about, is can you still trust the price? We believe we still can because we still see it in markets. And if more of the market is indexed, more of the market is indexed. And that's, you know, not necessarily an issue for us or what we're trying to get.
- [42:17]
Jack Forehand
I want to ask you about something that we've probably had the most divergent opinions on in the podcast, which is the small cap premium. You have some people who say there is a small cap premium. You have some people say there's not a small cap premium. Some people say there is one if you adjust it for low quality companies. We've had other people who say you want to use small caps, but you only want to use it within the other factors. So value is better in small caps. So you want to use it that way, but you don't want to use it on its own. There's so many different things. We had Bridgeway on recently and they wrote a paper where basically they showed that if you pull out IPOs and if you pull out fall in large caps, small cap premium return. So I'm just wondering, like, what, what are your thoughts in general? There seems to be so many opinions on this, this whole small cap premium.
- [42:54]
Matt Zenz
Yeah, I'd probably fall in the latter camp in terms of, you know, again, everything comes down to valuations and discount rates. Right. The reason why small cap companies have tended to do better is because there are companies with really attractive discount rates within small caps. There are also some companies with really unattractive discount rates within small caps. You just tend to see the extremes. And so if you filter out the extremes, the bad extremes. Right. So people will talk about that as like the junk names, or maybe it's the IPO and the fallen names or what have you. These names that look really bad from a valuation discount rate perspective, then the remaining ones look really good and tend to outperform. When you look at them holistically across the board and you include the bad with the good, you don't see anything. And so it's more a function of there are more companies within small caps, you see more extremes within small caps. And so when you factor out the quote unquote junk, then the ones remaining do better. Now, I would say they're not doing better because they are small. They're doing better because they have really good discount rates based on the valuation, based on future profits and the current price. They just happen to be small and you see more of them within small caps just because there are more small caps and you see more deviations. Like a massive top 10 company is just not going to have as extreme valuation ratios as you're going to see within small caps.
- [44:25]
Jack Forehand
Yeah, it was interesting. This is a point Wes Gray made when he came on. He was saying small cap value doesn't value doesn't outperform more in small caps because they're small. It outperforms because you can find more value in this. So in other words, you can find more value within the small cap universe than you can find in other places.
- [44:39]
Matt Zenz
Exactly, exactly. And so when you, when you're a factor investor and you tilt to value, profitability, those types of things, you valuation ratios, you tend to tilt to small because that's where you see the most extreme examples. And I think it's important to differentiate those two things because people just think small is going to have higher returns. It's not the whole story you need, it's really about the valuation ratio and that just happens to be in small.
- [45:03]
Jack Forehand
Do you think there's anything to this idea that the small cap universe is worse? I mean people point to two things. One is I think the number of unprofitable companies in the Russell is near, near all time highs. And the other is maybe some of the quality small caps are staying private longer now, so they're not coming in. So people argue those two things come together to make a worse small cap universe than we've seen in history. Do you think there's any, any truth to that?
- [45:22]
Matt Zenz
Not really, no. So I do hear this argument a lot and it seems compelling, right? You see the open AIs, the anthropics, the SpaceX and you're like, man, these companies stayed private this whole time. They're huge companies, they've been incredible investments. If I had just gotten access to it, if they had IPO'd earlier been a small cap company, I would have gotten it. And I think that suffers from a couple different cognitive biases. The first is survivorship bias. You only know those companies exist because they were successful. There's lots of companies that could have IPO'd as small caps at the same time. SpaceX could have, that went to zero. Think like WeWork, right? Like WeWork was an extremely popular company everybody was talking about, took a while before it was going to think about IPOing and it went bankrupt, it ended up not being able to IPO and ended up going bankrupt. So investors would not have been better off holding a name like that. So that's, that's one thing. The second is it's not like the historical small premium that we've seen has come only from companies who recently IPO'd. It's not like small cap companies are all companies that are only 5 years old recently IPO'd, and some of them are gonna go to the moon and that's how you're gonna get your return. There's always gonna be small companies for good reason. They just have lower values. And yeah, that's just not kind of the reason for the return. So the fact that SpaceX didn't IPO five years ago, where you could have captured it as part of the small cap premium, isn't destroying the small cap premium because that's not where it comes from to begin with. On top of that, a lot of these private companies are owned by public companies. So if you own Microsoft, you own part of OpenAI, if you own Google, Amazon, you own part of Anthropic. So these, these companies that you want exposure to, you do have some exposure through these public companies. And so ultimately, no, I don't think the small cap universe is worse. Is it different? Yeah, it's different. We've seen small cap premiums in every, almost every country we've looked at. Some of Those countries have 10 small cap companies, some of them have 100 small cap companies, some of them have a thousand. So I think the, you know, the decreasing number of names or the unprofitable ones or all of these things are things we've seen before in more extremes in other countries. And they don't give me any worry that like the small cap premium is dead or you're not going to be able to get the returns in public markets anymore or anything like that.
- [47:45]
Jack Forehand
Yeah, I think that survivorship bias thing with OpenAI is so important. It was funny, we had Michael Mobisen on, he was explaining a company to us and he went through all these amazing characteristics of the company and when you're listening to him, you're thinking, it's Microsoft, it's Google, it's whatever it is, it's one of these great tech names. And then at the end he's like, the company was Enron. That explains the whole thing though. When you looked at the stuff with Enron at the time, like that could look like, you know, that could look like some of the great companies. And it Ended up being a zero.
- [48:12]
Matt Zenz
Yeah. And like just there's a chart out there that has like the largest 10 companies by decade in the US and it's constantly changing. Right. And at the time it always feels like these companies are going to take over the world. And then 10 years later it's a different 10 companies. And you know, in hindsight it makes perfect sense as to why these ones are now the biggest versus those. But you're always going to get that rotation. Things are always going to change. You know, you can't rely on the, you know, the biggest winners in the past aren't necessarily the biggest winners in the future. They can go down. You know, Enron's a great example of that.
- [48:43]
Jack Forehand
One more, before we move on to bonds, I want to ask you about AI. Like, do you think for what you do, for the types of things you do, is AI going to be like significantly additive? Like on one hand I could argue, yeah, AI can find all these things. But on the other hand I could argue we've researched these factor premiums for a very, very long time and like AI might just, it might be beat to death to the point that AI is not going to uncover something that we haven't found already. Like, do you, do you have any thoughts on that?
- [49:05]
Matt Zenz
Yeah, I'm in the latter camp of like, you've had hundreds of academics all trying to get their PhD thesis looking at this historical data for decades and they've found about one meaningful thing a decade, right? You had, you know, the size premium, then value, then profitability investment. Like each of these, you know, good idea comes around basically once a decade in this factor type investing and this stuff spins. And on top of that, each subsequent factor that's been found explains less and less of the return because you already have a lot of it being explained by the prior ones. And so the amount of value being added on each subsequent thing is lower and lower. And now you throw AI into the mix where it can do tests on millions of different signals, find patterns that may or may not be patterns, it may just happen to have happened that way. And so I think there's a huge data mining risk there. I also think again, markets are super noisy. To say anything with any confidence, you need a lot of data going back historically. A lot of these AI data sets, they're pulling data from like the last five to 10 years and trying to say something meaningful that's just not a long enough period of time. Right. Like if you only look at the last 10 years in the US you would say that there's a growth premium, that I should invest only in growth stocks, that, you know, the opposite of the value premium. So you need many market cycles, many decades to really know what the truth is. And I think we're going to have a lot of, you know, short term type things with AI that ultimately is going to probably increase fees for investors, increase turnover, lower returns, and just end up being great for the asset managers who are doing it and terrible for the investors in those funds.
- [50:46]
Jack Forehand
I want to shift to fixed income. And fixed income is interesting because I feel like people like you and me are spending the vast majority of our time thinking about equities. Like, it's like a lot of the research is equities and people may not spend enough time on fixed income. And you've been, you've been working on fixed income recently and you've called it the quietly, the most inefficient corner of a client's portfolio. So can you talk about that and what you've been doing?
- [51:04]
Matt Zenz
Yeah, it's always tough talk about fixed income because people view that as like a snooze test, right? Like, equity is exciting. And listeners to this episode are probably like, all right, I'm done with this episode, turn it off. And I'm hoping people stick around for another 10 minutes because this is going to completely change how you think about fixed income. So as I mentioned before, you know, we are an RA as well. We manage individual clients money. And fixed income is extremely inefficient, both from an operational perspective and a tax perspective. I'm giving my money to somebody that I want just to stay invested and compound. And what happens is every single year they give me my money back in terms of that fixed income.
- [51:44]
Indeed Advertiser
Right?
- [51:44]
Matt Zenz
They're giving you that income back. And not only that, a slice of it is taken every single year by the government. And that goes to taxes. And it's at income tax rates, which is the highest possible tax rate. And so this creates huge inefficiencies, both in terms of reinvesting the money, having a compound, but then also a massive tax bill I have to pay. And so what we're trying to do is reengineer how people experience fixed income. From a tax perspective. Equities is a lot more seamless. I give my money to a manager and that money basically stays invested and it compounds. And when I want to sell it, I pay the tax. I control when I pay the tax, and it's much more efficient from that perspective. We want fixed income to be more like equities in that sense.
- [52:27]
Jack Forehand
It's interesting too, because the tax drag on a typical bond fund, I would assume is pretty substantial, right?
- [52:33]
Matt Zenz
Yeah, it can be huge, especially for people at the highest tax rate. Right. So if you think, you know, the US ag, let's just say is, it's a little over, but let's just say it's around 4%. Right now if you're at the 40% marginal tax rate, most people, you know, high income people are at that rate. You're paying 1.6% a year in taxes. So when we, you know, you look at over 20 years, that loss, compounding that tax drag that you're, that you're suffering ends up being about half the value of that fixed income investment. So you're losing half the return to taxes. And so that tax drag is, is, is huge. People, you know, people think about one investment over another, saving 10 basis points. Like, I'm going to pick this manager because their fee is 10 basis points less than this manager. Well, we're talking about a order of magnitude larger than that. We're talking about 1.6% a year being lost to taxes in these types of investments. So the drag is huge.
- [53:36]
Jack Forehand
It's interesting because fees are obviously very, very important in investing, but I feel like a lot of times people pay attention to fees more than they pay attention to taxes. And in a lot of cases, taxes are actually a much more significant fee than fees are.
- [53:46]
Matt Zenz
Yeah, that wasn't always the case because fees used to be a lot higher. And as fees have come down now, the tax piece is, is the monster in the room, the elephant in the room. And yeah, you're absolutely right. People are still focused on fees and they're missing the biggest one, which is taxes. And that may have partially been because they didn't think there's anything they could do about it, but now we think there is.
- [54:11]
Jack Forehand
So can you explain how you're tackling this problem with LVIG?
- [54:14]
Matt Zenz
Yeah. So as a starting point, LVIG's goal is to invest in investment grade US fixed income. So both Treasuries, corporate bonds, et cetera, in the roughly US AG type asset class. And the idea is, rather than receiving income, we want to capture the return through capital appreciation or NAV appreciation, rather than through fixed income. So it's getting the returns of fixed income, but not forced income. And the way we do that is by investing in underlying ETFs. So we invest in low cost diversified ETFs and then we rotate between them. And so around Dividend dates for different ETFs. We might sell one and buy a different one. And by avoiding that dividend, we avoid getting that distribution. And we don't avoid the tax, we just defer the tax. You then control when you pay the tax. It's when you sell the investment. And in the meantime, all of your money stays invested. All of it continues to compound and you get that benefit of, of, of tax deferral and compound.
- [55:30]
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- [56:02]
Jack Forehand
Have you thought about like how much the benefit could be of this? Obviously it varies based on tax rate and a lot of other factors. But I'm sure you've done some research in general to how we could think about that.
- [56:10]
Matt Zenz
Yeah, so the benefit is huge. And the reason the benefit is huge is because the opportunity is huge. Right. We already talked about you're losing 1.6% every single year to that tax tax drag. And so the question is, is how much of that can we recapture for clients? And so what we found is it's in the half a percent to 1% range that you can outperform on an after tax basis. And the reason for that is, is really a few things. So the first is that 1.6% you were paying every single year to Uncle Sam. That money stays invested and you earn a return. So you get to earn that money every single year. And every year you do this, that money just keeps on compounding and compounding and compounding and that return difference just grows and grows and grows. So that's just the benefit of deferral. Then the next benefit is the difference in tax rates. So by deferring tax, you're not avoiding it. It's just what am I paying in taxes today versus what may I pay in tax in the future? Similar concept to like a Roth conversion. Should I do a Roth conversion? Well, what is my tax rate today? What do I expect my tax rate to be in the future. There are lots of reasons why you might expect your tax rate in the future to be low. You could be in a lower income state, your income itself could be lower. You could get capital gains treatment, you maybe donate the shares or get a step up at death. All of these are reasons why you might have a lower tax rate in the future than you do today. And so that 1.6% annual drag, if you're a 40% income investor, if, let's say in the future when you decide to sell the investment, you get 20% tax treatment that ends up being about 80 to 90 basis points a year, an annualized after tax outperformance from that difference in tax rates. And so this is really about tax deferral tax control that you pay the tax when you want to. And depending on what you expect your future tax rates to be, that'll tell you how big the benefit is.
- [58:10]
Jack Forehand
I would think this would work for all taxable type investors. But are there certain types of investors where this type of strategy makes the most sense?
- [58:17]
Matt Zenz
Yeah, what we've seen is pretty much every taxable investor this makes sense. We haven't really found a case where it doesn't. As long as you are above like at something around the 20 marginal tax rate, which is something like 100k worth of income for a couple married filing jointly. So it's most investors this matters. And so it's, you know, if you are a long term investor, right. The longer you hold this, the bigger the benefit. Right. So if you're trying to buy fixed income for six months, maybe this is doesn't make much sense. But if you're a long term investor, I taxable investor at the 20% or above tax rate, this strategy makes a lot of sense. Your after tax long run returns are a lot higher. And you know, I always try to put my advisor hat on when I think about these types of strategies. And when you reduce your income today, it opens up tons of financial planning opportunities. Right. So now you can do more Roth conversions, maybe you can do capital gain harvesting. Now asset location becomes easier. Maybe you avoid net investment income taxes because your income is lower. There are so many or IRMAA surcharges or so many different financial planning ideas that advisors can then bring to their clients because they have more flexibility because the client's income is lower that you are controlling when you pay the tax rather than being forced to pay it every single year.
- [59:38]
Jack Forehand
Well, Matt, this has been awesome. I really appreciate you coming on. It's always good. I think at a time like this to get some, to get an evidence based take. I mean I, I was ready to talk about the Tam of Mars and now, now I'm kind of at least a little bit back into, into reality. So. Thank you. If people want to find out more about you or Longview, where, where can they go?
- [59:54]
Matt Zenz
Yeah, so we have a website, longview researchpartners.com that's probably the best place. Or you can reach out to me on LinkedIn. We're, you know, we're somewhat active there as well on posting things and, and yeah, that's probably the best way to reach out.
- [60:07]
Jack Forehand
Well, Matt, thank you again. I really appreciate you coming on.
- [60:09]
Matt Zenz
Thanks Jack. Appreciate it.
- [60:10]
Jack Forehand
Thank you for tuning in to this episode. If you found this discussion interesting and
- [60:14]
Matt Zenz
valuable, please subscribe on your favorite audio
- [60:16]
Jack Forehand
platform or 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
- [60:30]
Matt Zenz
should be construed as investment advice. Securities discussed in the podcast may be
- [60:35]
Jack Forehand
holdings of the firms of the host.
- [60:39]
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Matt Zenz
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