In Wildness is the Preservation of the World: The Thinking of Peter Thiel and H.D. Thoreau

There is a remarkable connection between two of my favorite thinkers—Peter Thiel and H.D. Thoreau. Each offers the same prescription for life, a prescription that we need more of today:

Live (and think) at the frontier, on the edge of discovery, not in the cozy establishment.

Favor radical discovery and exploration over incremental—and conventional—improvement.

Free yourself from the known, get lost in the hidden and unknown.

These passages are from Peter Thiel’s Zero to One and H.D. Thoreau’s essay Walking.

Thoreau: It is remarkable how few events or crises there are in our histories; how little exercised we have been in our minds; how few experiences we have had.

Thoreau: Hope and the future for me are not in lawns and cultivated fields, not in towns and cities, but in the impervious and quaking swamps.

Thoreau: My desire for knowledge is intermittent; but my desire to bathe my head in atmospheres unknown to my feet is perennial and constant. The highest that we can attain to is not Knowledge, but Sympathy with Intelligence.

Thiel: EVERY ONE OF TODAY’S most famous and familiar ideas was once unknown and unsuspected.

Thiel: The clearest way to make a 10x improvement is to invent something completely new. If you build something valuable where there was nothing before, the increase in value is theoretically infinite.

Thiel: You can’t find secrets without looking for them.

I think Thiel would agree that the best opportunities are “in the swamps.”

Thiel: As you craft a plan to expand to adjacent markets, don’t disrupt: avoid competition as much as possible.

Thiel: Indeed, if your company can be summed up by its opposition to already existing firms, it can’t be completely new and it’s probably not going to become a monopoly.

Thiel: Competition can make people hallucinate opportunities where none exist.

Both authors disparage the value of a conventional education (an attitude to which I am sympathetic):

Thoreau: In literature it is only the wild that attracts us. Dulness [sic] is but another name for tameness. It is the uncivilized free and wild thinking in “Hamlet” and the “Iliad,” in all the Scriptures and Mythologies, not learned in the schools, that delights us.

Thiel: The best place to look for secrets is where no one else is looking. Most people think only in terms of what they’ve been taught; schooling itself aims to impart conventional wisdom.

Thiel: The most contrarian thing of all is not to oppose the crowd but to think for yourself.

  Thiel: All Rhodes Scholars had a great future in their past.

In this next grouping, think of Thoreau’s “West” as “zero to one” and “East” as “globalization” or “one to N”

Thoreau: We go eastward to realize history and study the works of art and literature, retracing the steps of the race; we go westward as into the future, with a spirit of enterprise and adventure…To use an obsolete Latin word, I might say, Ex Oriente lux; ex Occidente FRUX. From the East light; from the West fruit.

Thoreau: The West of which I speak is but another name for the Wild; and what I have been preparing to say is, that in Wildness is the preservation of the World. Every tree sends its fibres forth in search of the Wild. The cities import it at any price. Men plow and sail for it. From the forest and wilderness come the tonics and barks which brace mankind. Our ancestors were savages. The story of Romulus and Remus being suckled by a wolf is not a meaningless fable. The founders of every State which has risen to eminence have drawn their nourishment and vigor from a similar wild source. It was because the children of the Empire were not suckled by the wolf that they were conquered and displaced by the children of the Northern forests who were.

Thiel: The act of creation is singular, as is the moment of creation, and the result is something fresh and strange… the best paths are new and untried.

Thiel: The paradox of teaching entrepreneurship is that such a formula necessarily cannot exist; because every innovation is new and unique, no authority can prescribe in concrete terms how to be innovative.

Thiel: Indeed, the single most powerful pattern I have noticed is that successful people find value in unexpected places

Thiel: There are two kinds of secrets: secrets of nature and secrets about people. Natural secrets exist all around us; to find them, one must study some undiscovered aspect of the physical world. Secrets about people are different: they are things that people don’t know about themselves or things they hide because they don’t want others to know. So when thinking about what kind of company to build, there are two distinct questions to ask: What secrets is nature not telling you? What secrets are people not telling you?...Secrets about people are relatively underappreciated. Maybe that’s because you don’t need a dozen years of higher education to ask the questions that uncover them: What are people not allowed to talk about? What is forbidden or taboo?

Thiel: At the macro level, the single word for horizontal progress is globalization—taking things that work somewhere and making them work everywhere. China is the paradigmatic example of globalization; its 20-year plan is to become like the United States is today…The single word for vertical, 0 to 1 progress is technology. The rapid progress of information technology in recent decades has made Silicon Valley the capital of “technology” in general. But there is no reason why technology should be limited to computers. Properly understood, any new and better way of doing things is technology… most people think the future of the world will be defined by globalization, but the truth is that technology matters more. Without technological change, if China doubles its energy production over the next two decades, it will also double its air pollution. If every one of India’s hundreds of millions of households were to live the way Americans already do—using only today’s tools—the result would be environmentally catastrophic. Spreading old ways to create wealth around the world will result in devastation, not riches. In a world of scarce resources, globalization without new technology is unsustainable.

Thiel and Thoreau are great, but it is hard to top yet another author with a “T” surname.

The Road goes ever on and on

Down from the door where it began.


Still round the corner there may wait

A new road or a secret gate,

And though we pass them by today,

Tomorrow we may come this way

And take the hidden paths that run

Towards the Moon or to the Sun.

The road doesn’t have to be infinite after all.

Take the hidden paths. – J.R. Tolkien

So where are the hidden paths? This is the million (or billion) dollar question. As many great creative thinkers have said, the hard part is to find the right problem/ask the right questions.

For now, I can offer one suggestion: journey inward. We spend so much time collecting information so that we can know more, but tend to spend very little time getting to know the knower.

Having spent many hours across several years developing a meditation practice, I can attest that inward exploration is equally difficult and rewarding.

The mindset that slowly develops with a consistent meditation practice is compatible with wildness and the existing on the frontier. You learn to look at the world with a fresh, open set of eyes. Meditation helps you develop what’s known as a “beginner’s mind,” a mind unencumbered by convention and accumulated baggage. I’ve noticed I use two words a lot more now: “why” and “no.” These two words, used liberally, are powerful. They’ve made me happier. I think they can do the same for you.


P.S. can you believe I got through a Thiel post without asking/quoting “what important truth do very few people agree with you on?” Oh wait, I already did that post.

Lessons for Investors and Entrepreneurs: The Nature of Value

It is always fun to read a book that is useful for investors and entrepreneurs/businesspeople. Nick Gogerty’s The Nature of Value covers a lot of ground—below I quote and highlight some of the most useful lessons and idea from the book. I also met Nick last week, and it helps that he is a very nice and smart guy.

VALUE, IN THE SIMPLEST sense, is the human perception of what is important. As such, it is subjective and context dependent.

I have to remind myself often that market prices are a collective opinion or perception, and that the only sustainable advantage in investing is finding perception (price)/reality gaps. The book talks a lot about changes in the perception of value, and how quickly a hot technology can fade away, its value diminished.

Evolution…favors the energy efficient.

all things can be considered dissipative structures—that is, all forms evolve for energy to flow through at increasing levels of efficiency. We will see that the study of evolution across economic and ecological domains is actually the study of dissipative structures adapting over time and through selective processes.

I love Peter Thiel’s definition of technology which “to do more with less.” This is a key lesson for the entrepreneur (companies like Uber and Airbnb--efficiency machines--best exemplify these ideas), but also for businesspeople. Companies tend to add layers of bloat over time and must constantly fight this slowly accumulated business baggage. It’s very hard to innovate as companies get older and older. Gogerty continues:

Innovation, as suggested, is both a giver and a destroyer of value. The entrepreneur—and society—sees innovation as a positive option that can potentially deliver new forms of value. But innovation expressed outside one’s own firm is a negative option viewed from the firm’s perspective. A competitor’s positive option can kill other firms. This negative optionality is unpredictable and extremely difficult to avoid. The allocator must guess the scope and scale of negative options that may be created by others. Firms with well-known fat margins can become negative option magnets, attracting entrepreneurs.

Negative options look like radical innovation to existing competitors. James M. Utterback, an MIT professor of innovation, has done in-depth innovation research and said the following about radical innovation and corporate death. A product’s life could end quite suddenly with the appearance of a radical new competing product that invades and quickly conquers the market. Not many firms have the dexterity to retool their capabilities in order to survive successive waves of innovation. Over the life of a product, few of the firms that enter the market to produce the product survive. Firms holding the largest market share in one generation of a product or process seldom appear in the vanguard of competition in the next.

This means that, surprisingly, no technology leader managed to hold onto the lead in the next iteration. For an investor in the technology sector, the leading firm must provide incredibly high returns on equity due to the short value-creating life span. Innovation-led companies are often severely overpriced, with little regard for the forces of negative optionality that lead to short life spans. Looking at the big picture over time makes this obvious. Focusing on today’s single “lottery ticket” firm ignores the silent negative options held by others.

One of the best finds in the book is a list of ten aspects of innovation made famous by the Doblin Group. If you work at a business or plan on starting one, going through this list is very valuable. Check it out here. You want to be unique in as many of these ten ways as possible. Having just one or two advantages probably won’t cut it:

Businesses that rely on a single unique capability for market share or margins are highly vulnerable to negative optionality (we explore businesses like this in chapter 6, in the discussion of “hero products”). Many technology firms fall into this category, and thus are weak candidates for sustainable value creation and capital allocation. Paradoxically, many of these firms are mispriced at high earnings multiples.

This story about Mark Twain reminds me of the cautious tale of automobile companies (which consolidated from more than one hundred to three major companies). Someone with a crystal ball about future technology might still fail to make any money from their knowledge of the future because competition is so fierce and it is hard to pick the winners!

History is filled with famous lottery ticket betters. The author Mark Twain was an early venture capitalist. He correctly saw the potential of the early typewriter, and invested in it. The typewriter flourished as a smash hit product for over a century, but the particular firm Twain bet on didn’t last long. Twain lost so much money he was forced to go on a global speaking tour to recoup his losses.

I also found lots of subtle references to the idea of shareholder yield investing (which is a preference for disciplined capital allocation).

Investors should beware, as well, of firms that are pushing innovation simply for the sake of innovation. This is usually nothing more than costly activity, driven by fear, masquerading as productivity. Bad innovation like this happens all the time, and is endemic at firms where analysts, boards of directors, and shareholders insist on “pushing the envelope” and keeping up with R&D initiatives regardless of the return on invested capital (ROIC). Activity like this may push share prices up in the short term, but it does not create value.

A typical organizational response to the cluster death process is to fight to the last penny even as it destroys shareholder equity, which is perversely considered more noble than quitting and handing back shareholder capital.

Allocators should seek long capability-cycle processes with fast, efficient cash flow turnover cycles. Expanding on the biological metaphor, bet on a slow, stable niche and a stable, quick-learning species within that niche that survives and thrives relative to others.

Our research shows that these ideas are right. Companies paying down stakeholders (buybacks, debt payback) significantly outperform those issuing new capital.

Finally here are some fun fast quotes from the book. I highly recommend it.

Remember Henry Ford’s saying that many people missed opportunity, because it showed up dressed in overalls and looked like work. [I always thought this was Edison, but forget it, he’s rolling]

Having the best product doesn’t matter. Efficiently delivering the best perceived user experience is what determines survival.

A cheap ticket on a sinking ship is never cheap enough to make the ride worthwhile. [i.e. a value strategy can probably be improved using other metrics—avoid the absolute worst quality can help in some situations…more posts on this in the future]

I suggest books like this once per month to members of the book club, you can sign up here.


How Expensive Are Expensive Tech Stocks?

The answer: not much more expensive than OTHER expensive stocks in the market. Granted, this is all based on publicly traded companies, not privately funded start-ups. If I had a thorough history against which to compare current fintech or other start-up valuations this might look quite different. 

But here is the story. This chart shows the EBITDA/EV yield (higher = cheaper) for both tech stocks and the overall market. On top is the median valuation for tech vs. market, and on bottom is the EBITDA/EV yield for the most expensive 10% of tech vs market. You can see that in the late 90's/early 00's expensive tech stocks were MUCH more expensive than expensive stocks in the market in general. Not so today.

Its also fun to look at the median valuation difference between tech and the market median. Tech is typically 25% more expensive, and today is 20% more expensive based on EBITDA/EV yield.

Doesn't exactly scream bubble, does it!

Does Value Still Work?

Everyone knows about value investing now, and everyone is tilting towards value, so its going to stop working. Everyone is saying this to me lately--sometimes as a question, sometimes as a statement of fact. 

Yogi Berra famously said, "no one goes to that restaurant anymore, its too popular." Is the same thing happening to value?

The most common definition of value, courtesy of Fama/French, is book/price. But book/price has many limitations. It is not as effective as a combination of other factors which work better in large cap (B/P works best in illiquid small/micro cap). We prefer a composite factor (equally weighted calculation using s/p, e/p, ebitda/ev, fcf/ev and shareholder yield).

Here are the rolling 10-year excess returns (versus an equally weighted benchmark) for two value factors: book/price and the value composite. You can see that 1) the composite is vastly superior to B/P alone and 2) the very simple trend lines are moving in opposite directions. 

I don't read a ton into the declining B/P trend line. I think that value works because it exploits behavioral issues in the market and because so few investors can stick with it. Case in point, a book to price value investor has underperformed for the last 10 years.  I still think even B/P will work in the future. But the data from the value composite debunks this idea that value is dead. 

What Millennials Want (Or, How You Can Win Their Business)

Millennials are still in the very early stages of market participation: those under 35 own just 4% of mutual fund assets, but the 80-90 million millennials will soar in importance to everyone in the wealth/asset management business before too long. Through inheritance alone, millennials stand to receive $30 trillion in the next few decades. Where they start will often be where they grow. Some, like Wealthfront and forward thinking financial advisors, are tapping into this young potential already. So, if you are in the financial services business, how can you do the same?

I’ve learned a lot about young people and what they want since publishing Millennial Money late last year, and I believe these findings are relevant for financial advisors, millennial investors, and all those trying to win their business. The book has given me great access. Here’s what I’ve learned.

Young People Don’t Trust You

Millennials have a big issue with trust. In a very recent survey of wealthier millennials, just 19% agreed that advisors in general have their clients’ best interests at heart. 40% actively disagreed with this notion. Millennials are selfish (in a good way): with everything they buy, they want to know they are getting the most value possible for the price. In this same survey, 72% of them responded that they are “self-directed” investors and 41% said they’d received no financial advice.

Most of the millennials in this survey had more than $3M to invest and more than a quarter of them had more than $10M. They equated advisors with salesmen.

The solution is to educate them, rather than sell them. I like the idea that “when you sell, you break rapport, but when you educate, you build it.” [i]

This education can come in many forms. Regular white papers, commentary, blog posts, even twitter messages that teach investors why your style of investing/way of doing business makes sense and will work. If you are a financial advisor, do an event with your clients AND their children. The single most effective event I’ve done was a night at a club in LA, hosted by one of the best advisor teams we work with. I made a short presentation to 50 or so young people, many of whom were the children of the advisor’s top clients. These people were extremely hungry to learn, but just hadn’t had the chance or the time. I’ve heard from many of them since that night and two things stand out. One, they want to hear more about investing strategies, and two they want to build a relationship with an advisor who can help them learn.

Education is key. It builds trust and can secure multi-generational relationships.

Young People Like Three Key Attributes In Investing Strategies

A specific style of investing strategy resonates with millennials. Three criteria stand out: these strategies are rules-based, transparent, and mindful of fees and costs. Millennials have thus far liked index funds because they meet these criteria so well. I am naturally a bit biased given that O’Shaughnessy Asset Management manages quantitative/systematic strategies. We like to think that we are marrying the best aspects of active and passive investing: the disciplined, consistent, rules based approach of an index with a much more effective strategy based on principles like valuation, quality, momentum, and total yield.

Millennials like index funds, but they also like systematic strategies. I won’t explore Smart Beta here, because it means so many things, but the idea of a rules-based, systematic strategy has resonated well with young investors. They can understand it because they understand the rules. They are transparent. They tend to charge reasonable fees. Only 20% of wealthy millennials though that fees in our business were reasonable. Reaching them with these kinds of strategies works. They like index funds, but are also open to active strategies.

Young Investors Will Demand Automation—So Embrace Technology Now

Have you tried signing up for Wealthfront or Acorns? I have. It’s insanely easy. I get physically uncomfortable and annoyed when I want something and I can’t get it easily—in under 10 minutes, from my iPhone, sitting on my couch. And I am probably on the patient end of my generation. We are spoiled rotten by technology, so financial services solutions need to be easy, accessible, and fast as possible. Obviously there will be limitations depending on your line of business, but the smoother and easier and more automated you can make the experience the better your chances with millennials now and in the future.

If you run a business and don’t have a programmer, hire one. If you have one, hire more. At O’Shaughnessy Asset Management, our large programming team has become the lifeblood of our firm. We are quantitative investors who test myriad different strategies on historical data. Back in 2007, when I had an idea that I wanted to test, it took me roughly 36 hours to set up the test, run the historical simulation, collect the results, and perform the analysis. That same sequence takes me about 10-15 minutes today. I can answer just about any question about market history in minutes because of the technology at my fingertips. Doing the same in your business by automating as much as possible can make a huge difference. Imagine if all the repetitive tasks associated with your business went away, and imagine the time that would free up to focus on the areas where you are really skilled. These kinds of tasks are a hassle, removing them is good for you.

I am no proponent of modern portfolio theory or the efficient market hypothesis, yet I still send tons of people to Wealthfront. I do so because it is so easy that I know people will actually get started, and because friends who have $10,000 to invest will appreciate the very solid service. It’s not perfect, but it’s infinitely better than doing nothing. In ten years, those same people might have $1,000,000 with the same company.

Don’t Be Evil, Be Human

I am repentant for my former skepticism of blogs and twitter. For a long time I thought they were unprofessional. I couldn’t have been more wrong. These venues sync up with the millennial audience so well. They are transparent, they build trust, they help you educate your audience, and to connect with them in a way that is human, not just professional.

I think that is all young people (or maybe just people) really want: helpful services, charging fair prices, offered by people who are fundamentally good and honest.

It is amazing how different the world of finance is. Here is a passage from Tragedy and Hope (an amazing history of the early 20th century), about banking and the bankers that more or less ran the world:

“they remained as private unincorporated firms, usually partnerships, until relatively recently, offering no shares, no reports, and usually no advertising to the public…This period, 1884-1933, was the period of financial capitalism in which investment bankers moving into commercial banking and insurance on one side and into railroading and heavy industry on the other were able to mobilize enormous wealth and wield enormous economic, political, and social power. Popularly known as “Society,” or the “400,” they lived a life of dazzling splendor. Sailing the ocean in great private yachts or traveling on land by private trains, they moved in a ceremonious round between their spectacular estates and town houses in Palm Beach, Long Island, the Berkshires, Newport, and Bar Harbor; assembling from their fortress-like New York residences to attend the Metropolitan Opera under the critical eye of Mrs. Astor; or gathering for business meetings of the highest strategic level in the awesome presence of J. P. Morgan himself.”

Some might argue that this still happens to some extent today. But remember that when millennials were asked to identify their ten most hated brands, the four big banks all made the list.

Google’s motto “don’t be evil” is a great starting point for the financial services industry today.

Getting Them to Act Is the Hardest Part

Usually we need to be discontent or frustrated to take action. The further away a problem is in time, the less motivated we are to do something about it. The problem should be clear: millennials have decades before retirement.

The philosopher Eric Hoffer wrote an amazing book on mass movements called The True Believer, which I recommend to everyone. In the book he says, it is not the distant kind of hope, but the “around-the-corner brand of hope that prompts people to act.” It is so hard to envision a period 40-50 years in the future, and even harder to get people to act for a reward so distant. I’ve learned this firsthand the hard way. I spent too much time selling young people on 40-year returns, trying to appeal to their reason. They all nod their heads, agree, and then do nothing.

Instead I should have been appealing to emotions and immediate needs. If you are an advisor, don’t just sell the potential for long term wealth (although that is good), but also the benefits of working with you that they will feel immediately that may be frustrating them now.

Think of Maslow’s pyramid, his hierarchy of human needs. People will act most readily to satisfy their most basic needs. In the case of investing, shelter is key. Millennials need the equivalent of a financial shelter, but with a negative 2% savings rate, they aren’t building financial shelters. I think introducing first the idea of building a financial shelter—to cover short term needs when they arise—is a powerful way to get millennials interested and started saving.

Investing comes next. Again, a 40 year compound growth number sounds great, but it doesn’t precipitate action. So frame it differently. We are twice as sensitive to losses and negative things as gains or positive things. Frame the need to invest negatively. Don’t say invest with me and you’ll be rich in 40 years. Say save and invest more now and you won’t risk being without support now and in the future. You might think this is a slimy sales tactic, but it’s not. Anything that gets young people started sooner is a good thing.

Consider this. Two groups were asked to explore a virtual world using virtual reality goggles. In the virtual world, the members of each group eventually came across a mirror which showed either their current face or a version of their face which had been digitally enhanced to make them look like what they will at age 70. When asked later in the experiment, the group which saw the aged photos said they’d plan to save at twice the rate as those which saw the normal photos. The effect of the aged photo made them emotional but also made old age seem closer, and more immediate. These are useful lessons in motivation.

Playing the Millennial Long Game

Young investors haven’t built up a huge collective fortune—so right now they are not the biggest or most important clients. By time will take care of that. Should robo-advisors—who are counting on riding this millennial wave—be valued at the multiples they are? As a group, probably not. But one or more of them will be huge because they are finely tuned in to the preferences of their current and prospective clients.

I believe that the profile of a firm or strategy that will win millennials’ business and help them succeed is as follows. It will use technology to automate as much as possible and make working with the company easy and efficient, because millennials will demand it. It will be transparent and good. It will focus on rules based asset allocation and selection strategies with low fees. Finally, it will deal with them in a way that educates and builds trust and provides not just solid long term results, but also immediate help in areas that millennials are frustrated.

As Gretzky always said, skate to where the puck is going.









[i] I believe this was from Chet Holmes, but cannot remember for sure. 

Why The Grandpa Portfolio Will Crush The Millennial Portfolio

Ever heard that joke about how if you are young and you aren't a democrat, you have no heart, but if you are old and you aren't a republican, you have no brain? Well, there seems to be something similar happening with the portfolios of young and old investors. Stocks with the youngest median owners are very expensive (but so exciting!), but stocks with the oldest median owners are much more fairly valued. 

I spoke at the CFA's 2015 national Wealth Management conference yesterday on the topic of "Millennials and Money" and sadly, I had to report that millennials are making three big mistakes: they aren't saving enough (-2% savings rate), their asset allocation is back asswards (very heavy on cash, light on stocks), and their stock selection stinks. 

It is this third category--poor stock selection--that I found most interesting. First, a quick reminder of how powerful valuations are for predicting future stock returns, on average. Value here is a combination of P/E, P/S, EBITDA/EV, FCF/EV and Shareholder Yield (deciles rebalanced annually). 

By just buying the cheapest stocks, you can significantly outperform over the long term (much easier said than done). Expensive stocks do so poorly that they have delivered a negative real return (after inflation). Simply put, you shouldn't buy expensive stocks (even though some of them crush, the group gets killed).

So now let's plot the stocks that have the youngest median owners (this is according to data from SigFig, which tracks 2.5 million portfolios representing about $350 billion in assets...their data is awesome). Look where they fall on the value spectrum.

I wasn't surprised by these (although I'm not sure what Blackberry is doing there...), but the key point is how expensive they are, on average. If you take them as an equal weighted portfolio, they are priced in about the 80th percentile of the market. Not good. Stocks in this valuation decile have done poorly through history. An average 30-year return would turn $1M into $5.4M (nominal). 

Now, let's contrast the millennial portfolio with the boring (but much better valued) grandpa portfolio:

This group of stocks is about as exciting as watching paint dry. And yet, taken as a group, it is priced to do much better than the millennial portfolio. Using the average historical return for stocks falling in a similar valuation bucket, the grandpa portfolio would grow from $1M to $46.2M over 30-years.

Millennials are notoriously skeptical of the market, but have started dipping their toes in with stocks that they know and love. Unfortunately, these stocks are priced to do poorly.  Millennials should embrace value investing, but value stocks are no fun. Returns earned from value stocks, however, are quite fun indeed. Millennials could learn a lot from their grandparents. 


The Very Cheapest Stocks (Price/Book) Do Very Badly

Book to price is a bad value factor. It is a decent stock selection factor overall, but relative to the other ways of measuring value (earnings to price, cash flow to price, EBITDA/EV, etc) it is sub par. 

I've been interested lately in very concentrated value portfolios, and found it interesting that when running very small portfolios (as little as 1 stock selected per month, with an annual holding period) based on book/price, you wouldn't have done very well (and would have lost money in the one stock versions!)

Here are the absolute and excess returns for concentrated book/price portfolios since 1963. It is not until you get to 25 stocks that the return of the concentrated portfolio edges out the market's average rate of return (11.45% in this period). I also ran concentrated portfolios of the most expensive stocks by book/price and was very interested to find that for the 5 and 10 stock versions, the expensive portfolios outperformed the cheap ones (barely, but still)! Once you get to larger baskets of stocks, then things normalize and cheap beats expensive. 

Let's consider the 5-stock version as an example (which underperforms the equal-weighted market by nearly 5% per year). Below are the rolling 3-year excess returns for that portfolio: consistently bad with occasional periods of brilliance. 


These stocks tend to be very different from other value stocks. The 5 cheapest stocks at the end of 2014, for example, failed to crack even the cheapest 1/3 of all stocks as measured by a composite value score (e/p, fcf/ev, ebitda/ev, s/p, shareholder yield). Four of the five have negative earnings, so look very expensive by other measures. 

Unlike with other value factors, these results suggest that you do NOT want to own a very small basket of stocks that are only cheap based on this mediocre measure of value. Stick to other value factors instead. 

More on Profit Margins

Jesse Livermore has a characteristically great and thorough look at U.S. profit margins up on his website, which I highly recommend. 

I've written about margins a few times in the past and find them fascinating. Jesse's key point is how important financial and technology stocks are to current U.S. profit margins, so I thought I'd add some fuel to the fire. Below are the top 24 stocks by contribution to overall margin in the U.S.

This means that Apple, for example, is responsible for 3.45% of the markets overall net profit margin (the math is (Apple's margin (21.6%) * Apple's share of the overall markets sales (1.27%) / the markets overall margin (7.98%)) = 3.45%). These 24 companies alone determine about 1/3 of the U.S. markets total profit margin. 12 of these 24 are financial or tech stocks--a notably disproportionate total given that these are just 2 of the 10 GICS sectors.

These 12 financial/tech stocks make up 19.5% of the markets margin. 

The future of U.S. margins, then, rest squarely on their shoulders. Their average margin is 19.8%. That is damn high! Who knows if these are sustainable, but these are the companies that matter most. I'd love to hear what you think about their sustainability. 

Buffett wisdom that you may not have heard before

I work hard to not quote or invoke Warren Buffett too often. His wisdom is ubiquitous and he doesn’t need another preacher. But I came across some unique insights from Mr. Buffett through a third party that I feel compelled to share.

These notes came from Jason Ke Wang (@Wangkejason), a graduate student earning his MBA at Stanford. I met Jason at our offices as he was in the middle of an incredible tour visiting many of the biggest names in investing: Bogle, Lou Simpson, Joel Greenblatt, and of course Buffett. He was generous enough to share his notes with me and allow me to share them here.

Buffett answered 16 questions across two and a half hours, and I was struck by several pearls that I hadn’t heard before (although I am sure he has mentioned elsewhere). Lots of what he said was similar to other statements he has made in public appearances and letters, but these ideas (or at least the wording of them) stuck out. Emphasis is always mine.

 On sourcing investment ideas:

“Found Berkshire in Moody’s Manual for Industries. You may think that today competition has increased and information is easily available but I used the same approach to find Korean stocks a few years back. Read the Korean stock manual one Sunday afternoon and found 15-20 stocks that way”

I love that old methods can still work. People are still lazy.

One of my favorites was this thought on the importance of speaking, writing, and communicating well.

At your age the best way you can improve yourself is to learn to communicate better. Your results in life will be magnified if you can communicate them better. The only diploma I hang in my office is the communications diploma I got from Dale Carnegie in 1952… “Without good communication skills you won’t be able to convince people to follow you even though you see over the mountain and they don’t”

On crisis management:

- If you have a city of 330,000 people (the number of people Berkshire employs) there are bound to be some people who are doing wrong. Try very hard to set the tone at the top. Send a two page letter to all employees every two years:

“We have all the money we need. We also have the best reputation one could possibly have. If you lose money, that’s something which is easy to earn back. But if you lose reputation, it is extremely difficult to earn that back. Act in a way such that if your actions were published in the local newspaper you would not be ashamed of your neighbors and friends reading that story. Play in the center of the field. I am old and cannot see the boundaries at the edge, don’t venture there”

- If a problem does occur there are four things you need to do

1. Get it right – get the facts right

2. Get it fast – move to action swiftly

3. Get it out – get it completely out of the system

4. Get on – move on

- Never let a problem sit unattended to

Misc others.

Long Term Capital (LTCM) – “they were right about everything except human emotion”

- Only way to stop a panic in today’s times is to have someone say with absolute authority, “I will do whatever it takes to make this right.”

- “The next panic will most likely come from a cyber/nuclear/biological or chemical attack on the US. The ability of psychotics, religious fanatics etc. to impact people has tremendously increased since 1945 (atomic bombing of Hiroshima and Nagasaki)”

- “The US will always bounce back. Our system really works, if you have cash during a time of panic, BUY”

- The auto industry has been the one of the most important industries during Buffett’s investing career. He has extensive knowledge of auto. Despite that he doesn’t feel comfortable buying auto stocks. Instead he chose to buy an auto dealer with 78,000 dealerships across the US. Simply because five years from now, he doesn’t know which model will sell but he does know that the auto dealer will sell it. This is the same story in tech, Buffett does not know who the leader will be.

“Every year I go the Microsoft Summit and face people with 180 IQs and tell them that if you asked me to choose between giving up a $10mn airplane and a $100 computer, I would choose the airplane. Why then, do you still charge me only $100 for the computer. You 180 IQs are not that smart.”

“It is very important to associate with people who are better than you, you will move in that direction. It’s just smart to do that. Not just people who are better in terms of IQ but also people who are better in terms of character”

As always, some great advice from Buffett. Thanks again to Jason for sharing. 

Technology Cash Machines

You'd be uncomfortable if you didn't have enough cash to pay your bills, right? Well its the same story for companies--its good to have cash to cover your short term liabilities. I was curious how balance sheets looked today by a measure called the cash ratio, which is a convenient measure of short-term liquidity. The results revealed an amazing trend in one corner of the market... 

The cash ratio is calculated as cash (and short term equivalents) divided by all current liabilities, where current liabilities are short term debt, accounts payable, income taxes payable, and misc other items. 

So how do stocks look? Do they have their liabilities well covered? Here is what the market's cash ratio looks like over the past few decades (higher is better)

Pretty damn good looking trend, eh? Well, the market has changed a lot. The majority of this trend is coming from one sector: cash rich technology stocks. Here is the same ratio broken out by sector:

These technology companies are like Scrooge McDuck, swimming in dough. All U.S. listed technology stocks are sitting on more than $800 Billion in cash and short term equivalents...almost double the next closest sector.  Oh, and these numbers don't include long-term investments (Apple alone has $130B categorized as long term investments, which many consider part of their cash hoard). 

as of 11/30, all U.S. listed stocks, Cash + Short Term Equivalents

Any thoughts on this trend? I am amazed by the ability of these technology firms to generate cash without significant liabilities. No wonder Silicon Valley is booming. 

5 Predictions for 2015

1.       Everyone will continue to make predictions despite overwhelming evidence that predictions are useless.

My father has been an incredible mentor, but you’d be surprised how few investing lessons he’s ever taught me. There were never lessons about ratios or sectors or discounted cash flows. Instead when I was growing up there was just one simple requirement: if you want something, produce a compelling argument and we will give you what you want. The emphasis was almost exclusively on how to think and how to build an argument with good evidence. I was rarely taught what to think.

But there is one thing he taught me which still sticks with me (mostly because I had no idea what the hell he was talking about, I was 12 years old). He said, “People are deterministic thinkers in a probabilistic world.”

Over the years I figured out that he meant was that we are pattern junkies obsessed with identifying patterns and extrapolating them into the future, and we fail because the future isn’t pre-ordained and deterministic. His lesson was: you should never bet on specific outcomes, but rather bet on high probability outcomes. This is very good investing advice.

But sadly humans don’t think like that. We see two of something and automatically predict a third. My favorite example of our pattern addiction is a study referenced by Jason Zweig in his book Your Money & Your Brain, which pitted humans against pigeons. Both humans and pigeons were show two lights, one red and one green, which were flashed 20 times per round. The lights were rigged such that the green one flashed 16 of the 20 times (80%), but other than this rule the sequence was entirely random. Rewards were given to people and pigeons when they guessed the next light correctly. The pigeons quickly figured out that the best strategy was to just guess green all the time, and their average score was about 80% correct. But us stupid humans, obsessed with prediction and patterns, constantly tried to outsmart the odds by guessing red occasionally—the end result being a score of just 68%. Stupid humans.

The best way to look at the future is as Howard Marks suggested in his last memo, “the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.”

Bottom line: I predict that our predictions will suck.

2.       Some book will be a massive bestseller, and no one will read it. We should create an award for this perennial snoozer and call it “the Piketty.” Mark Twain had it right: a ‘classic’ is a book which people praise and don’t read.

3.       Some asset class, currently despised, will explode upward. Energy stocks, perhaps[i]?

4.       I will announce a huge and very fun new project at some point during 2015—one that will require your help. I know this one is coming true ;)

5.       I hate predictions so much I can’t even come up with 5.

Happy Holidays!



Value + Momentum: The Tortoise and the Hare

Buy cheap stocks, or follow the trend? Two conflicting (and often exact opposite) strategies that have both worked well through market history. Momentum, when it’s working well, can be unstoppable for years. When it’s not working, it can lead to horrendous results relative to the market. Value has been steadier, but it too undergoes periods of significant underperformance. So what about combining these two ideas by looking for cheap stocks that the market is just beginning to notice? Think of the combination as the best aspects of the tortoise and the hare.

First, consider the results for a pure value and a pure momentum strategy[i]. Here are the rolling 3-year excess returns of these two strategies (best decile) versus all stocks since the 1960’s.

Notice that momentum is much choppier, but it has three separate 3-year periods when it outperforms by more than 20% per year for three years! Value only reaches that level once.

So what if you combined these ideas? I ran a series of tests combining value and momentum into a single factor, giving weights from 0-100 for both value and momentum factors—so, for example, a 50/50 combination gives equal weight to a stock’s momentum rank in the universe and its value rank in the universe. The long-term and rolling results for the best decile portfolios are listed below.

Best decile portfolios, 1/1965-9/2014

The best combination, measured by risk vs. volatility, was 70% value, 30% momentum. This strategy focuses on cheap stocks, but avoids those that are still in relative free fall versus the market. Check out the best and worst case 3-year returns for pure momentum. At one point (late 90’s) it outperformed by more than 34% per year for three years (that is more than 140% cumulative outperformance). Of course momentum was terrible during the market recovery following the 2009 bottom, underperforming by more than 13% per year for three years, causing many to abandon the momentum strategy.

In the rolling returns above, you can see that combinations of the two factors are much steadier performers. Value was crushed in the late 90's, for example, but including some momentum in the mix would have mitigated the damage. 

With factor investing all the rage, it’s good to know that both of these strategies work, and that they work at different times. But the most powerful combination is a strategy that measures both value and momentum at the stock level. Both value and momentum have had 3-year periods where they underperformed the market by more than 10% annualized. But the worst case for a 50/50 combination of value and momentum? Just 5.5% annualized underperformance over three years.

Bottom line, the tortoise and the hare both have their merits: cheap valuations rule AND the trend is your friend. Look for stocks that have both.

P.S. while these two factors are powerful, other factors matter too. Value and Momentum are two of the five factors that I explore in Chapter 6 of Millennial Moneyso check out the holiday offers for the book over here.

[i] Momentum is defined as trailing 6-month total return, value is defined as a combination of price-to-sales, price-to-earnings, EBITDA/EV, and Free Cash Flow/EV.  The best decile portfolios are rebalanced on a rolling annual basis. 

Value and Glamour Investing, Re-Envisioned

Did you know that the best performing glamour stocks outperform the best performing value stocks? Sounds exciting, right? Well it may be, but expensive stocks still stink. In this piece I visualize the performance of value and glamour stocks (inspired by and originally designed by the director of research at OSAM, Chris Meredith) in a new way to make the point once more that value trumps everything. 

Why in the world do people buy expensive stocks? Every shred of academic evidence shows that they underperform over the long term, and yet we keep buying.

We do this because we are so focused on the spectacular possible outcomes when we should instead be focused on the more sobering probable outcomes. I’ve referred to expensive stocks as lottery tickets in the past, because while investing in a group of expensive stocks (or lottery tickets) is usually a bad idea, sometimes you’ll get a winning ticket.

In the case of glamour stocks, these winning tickets have yielded incredible returns. Last October, Tesla and Cheniere Energy were the two most expensive large stocks trading in the U.S. Tesla was priced at 15 times its sales, Cheniere at 35 times sales. And yet over the next year, Tesla was up +51% and Cheniere +88%. People see results like this and think “valuations be damned.”

I define glamour stocks as the most expensive 10% of the market (rebalanced annually) by measures like p/sales and p/earnings. Glamour stocks as a group do poorly, but digging a little deeper we see that some are huge winners. Within the glamour stock universe, I sort stocks based on their forward 12 month return into ten equal groups.  The average results are illuminating:

You notice that the best performing glamour stocks beat all stocks by an average of 115% over the coming year. Talk about winning the lottery. But here is the problem: the median glamour stocks lost to the market by -11%, on average and the worst glamour stocks lost by 75%. Over and over again, we are seduced by the possibility of earning huge excess returns and blinded to the probability that we will underperform the market. Probabilities are boring, possibilities are exciting. But probabilities are all that matter in an uncertain world.

The first lesson, as always: some expensive stocks kill it, but the category stinks.

There is a flip-side which is much more enticing. Howard Mark’s (and many others successful investors) always highlight the importance of asymmetry in the investing process. The best way to succeed is to follow a strategy which is skewed in your favor on the upside.

In a recent memo, Marks said, “The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls.  But that doesn’t mean the avoidance of all losses is a reasonable objective.  Take another look at the goal of asymmetry set out above: it talks about achieving a preponderance of gain over loss, not avoiding all chance of loss.” (his emphasis)

With that in mind, check out the same results for the value portfolio:

This shows that value investing offers the right kind of asymmetry that investor should seek: on average there is more to gain than to lose, because while some value stocks get killed, the average ones significantly outperform the market on an annual basis.

Glamour/lottery stocks, by contrast, have the wrong kind of asymmetry: some do exceptionally well, but the average ones significantly underperform the market.

It is fascinating that if you could see the future, you’d do the best if you bought the best of the glamour stocks: the best performing glamour stocks outperform the best performing cheap stocks. But you can’t predict the future, so don’t try. Forget the splendiferous possibilities of glamour stocks and focus your portfolio in value stocks that offer the highest probability of success. 

Favorite Interviews

Interviews are my favorite. Lighter than presentations and easier than long pieces of text, interviews can provide fun and digestible insight into a topic--just look at the rise of the podcast!

Here are my favorite interviews so far:

Talking all things investing (whether you are a millennial or not) with the great Morgan Housel of the Motley Fool and Wall Street Journal

Talking millennials and money on Squawk Box

A wide ranging discussion with Carol Massar on Bloomberg Radio

Have a great weekend!


How Much Capital is Needed To Produce Sales?

How much capital is required to produce sales? I think this is an interesting question across U.S. economic sectors. Some sectors require boatloads of capital, others very little. Below are two looks at capital intensity (using capex-to-sales and assets-to-sales). For both, higher numbers indicate more capital intensive businesses. 

Utilities and Telecoms are traditionally the most capital intensive sectors, requiring tons of assets and capex to produce sales. Conversely, Consumer stocks have traditionally required far fewer assets to produce sales. Of note is the major rise in Capex/Sales for the energy sector, as more expensive means of extracting fossil fuels (tar sands, shale, etc) have become more important. 

 In a future post I'll analyze whether or not these have been useful factors for stock selection, both within and across sectors. 

How do you think capital intensity should factor into the investing process? I'd love to hear your thoughts below on the utility of these factors.