While this podcast does hover around the growth vs. value debate, we will hone in on the misunderstanding of innovation and how a simple financial reporting measure can cause trillions of investor dollars to be misallocated.
This podcast is the most important podcast that I have produced!
Geremy: Welcome to the podcast Deconstructing Alpha. I'm your host Geremy Van Arkel director of strategies at Frontier Asset Management. Deconstructing Alpha is a podcast where we respect the art and science of Investment Management. And we miss long form journalism, and can't find it anywhere on the internet, to anything that actually kind of makes sense. So we're inventing our own. And in this podcast, we interview who we believe to be brilliant investment managers, about topics that are currently occurring in the marketplace, and about different ways to actively manage portfolios and how to add value to to the clients outcomes. Today, I'm joined by as usual, Shannen Carroll, who is in the global headquarters of money management, Sheridan Wyoming.
Shannen: Hey, Geremy, how are you today?
Geremy: Excellent. Good morning, do we have a weather report from Sheridan, Wyoming?
Shannen: There's a lot of snow on the ground. But overall, I'm pretty, you know, doing pretty good, pretty well.
Geremy: Does this feel like the winter of discontent now that we are sort of in the middle of winter and at the same time, we're kind of having troubles in the investment markets. So what do we can we use that term? Or I don't think it's that bad yet.
Shannen: No, I don't think it's that bad. Yeah.
Geremy: So today, who are we interviewing today?
Shannen: We're interviewing Brad Newman.
Geremy: So Brad Newman is the director of market strategy at Alger funds. And for those of you who don't know, Alger is a specialist growth manager. And they're located in New York, and they have a long history of specializing in growth investing, and really are one of the one of the first real pure growth investment firms. And, you know, Shanen, you probably are aware that growth stocks have really outperformed value stocks for quite some time. So and a lot of the research the academic research behind markets, implies that value stocks should outperform growth, and that really hasn't materialized for quite some time. And the differences between growth stock performance and value stock performance have been dramatic. And so I think, you know, I'm not really I don't think this podcast is really returning to that age old age old art argument of, you know, is growth better than value. Obviously, in today's market environment, people invest in both growth and value. But I think there is some information that is going to be uncovered here, because I've been reading Brad's research, there's going to be some information that's uncovered here, that is going to be eye opening, about the differences between growth and value, and how the Marketplace is structured, and how people are investing based upon the difference between based upon this academic theory, and what's actually happening in the marketplace. And so, having come up a year, where growth stocks have clobbered value stocks, I think this is a extremely timely subject. And I think if we get this message out here about what the major difference between growth and value is and how it's being applied in the marketplace and how it's created imbalances. I think if we get that message across this is gonna be borderline groundbreaking, this is gonna be a really interesting podcast.
Shannen: Yeah, I'm really looking forward to breaking it down with you after after the interview.
Geremy: I hope I do the subject justice, because I know that people have been dancing around this growth versus value and arguing about it for decades. And but this is something completely new to think about. And so I just can't wait to get into this with Brad Newman from Alger and he's coming from Alger and you know, as somebody affirm that steeped in growth research, I think this is going to be eye opening to a lot of people. This is going to be a really cool podcast. So is there anything you'd like to leave our listeners with Shannon, before we get started here?
Shannen: Yeah, just to stay tuned for the disclosures at the end of the podcast.
Geremy: Yeah. And our breakdown, I think the breakdown here is going to be pretty important, because I think there's a lot of information here. And so everybody, please tune in, put your earbuds in go for a walk. And listen to this, this is going to be cool. Ladies and gentlemen, Brad Newman, Alger funds. Brad, welcome to the podcast. How are you doing?
Brad: I'm doing great. Thanks for having me.
Geremy: Yeah, so glad that you're here. This is I think is going to be an extremely timely podcast. So, Brad, where where are you located right now?
Brad: I'm in right now cloudy Greenwich, Connecticut.
Geremy: Yeah, well, I grew up not too far from there in Fairfield, Connecticut.
Brad: It's certainly a nice place to bring up kids. And it's, definitely kind of insulated from a lot of real life outside on outside of Greenwich. And it makes you know that that part actually makes my job difficult. Because while I'm a Wall Street strategist, we'll get into that in the moment. You know, it's critically important to understand what's going on on Main Street with median type families. And so yes, Greenwich's not real life for many folks.
Geremy: Okay, well, good. So are you located. Are you looking at you at home because of continued COVID responses? Or is it you know, happy Friday, and it's nice to work from home?
Brad: Well, we're hybrid at Alger. So we go into the office for you know, several days a week and are able to work from home, sometimes I find that I'm just generally more productive at home, get to read and put my head down and write and stuff like that. So when I can I try to do from home.
Geremy: Yeah, it's amazing how productive we've all become. I've taken the opposite stance, since there's really nobody on my entire floor in my office, my office has become my own personal condo, and it's a very nice quiet place. And it's just amazing how productive you can be without, you know, a lot of distractions. So tell me, what is your role at Alger?
Brad: Yes, I'm director of market strategy, which is a way of saying that I've kind of focused on the the macro, the macro economic, the topical themes, like innovation, I talked about a lot. Behavioral Finance cycles, like Federal Reserve cycle, political cycles, all those things, how they affect the markets and our strategies. And so I've talked to our retail clients and our institutional clients about those big picture topics and what that how that may affect our strategies and our clients portfolios.
Geremy: So was your origins on the investment side? I did notice that you have a CFA did you start as an analyst Portfolio Manager?
Brad: Yeah, I've done a fair amount I've done bottom up and top down. So bottom up, I've done on the sell side and the buy side. So I worked on sell side equity research a little place called Schroeder's and also Credit Suisse, where I covered things like homebuilders and telecom stocks. And, then I set the bottom up on the top down I've worked with earlier in my career worked with a couple of Chief Investment Strategist at Credit Suisse. To do kind of this, this macro stuff that I'm doing now. And then I spent a while just on the buy side, a couple of large, New York based hedge funds, just mostly mostly picking stocks, but working all throughout the capital structure, debt, derivatives as well. And so now I'm really more on the client side than actually pulling the trigger and making investments.
Geremy: I think it's interesting that in COVID, after COVID, your role is very similar to mine. I don't have an extensive background as yours. I was my backgrounds pretty narrow. But I think it's interesting after COVID, that this role that both you and I sort of are filling, you probably do it on a much larger scale. But the strategist role is kind of what I call it, I'd never really met anybody that was sort of part investment, part marketing, part research part economics, I'd never really met that person before. And then after COVID I'll have you know, that it, I meet those people all the time. And I think, I think COVID has really brought this role more to light in the investment process. So and I find that, you know, maybe I'll pay your compliment here, but I find that the analysts types that are more creative, I think, fall into this role right.
Brad: I think there's a couple of big drivers for why people are hungry for this and why demand is increasing. One is that thought leadership is more valuable, I think now than ever, you know, fees are coming down for all sorts of asset management products. And the portfolio management piece, while important in some cases is you know, there's many places to go for it, and people need to make sense of it. And so, to make sense of it, rather than having this relationship, you know, with a wholesaler or whatever you have where you used to get taken out to dinner or taken to a ball game. I think now the emphasis is really on give me useful information that will help, you know, me educate myself or my clients. I think that's one big piece. And the second big piece is, you know, the macro economy, macro trends, I think are impacting investing as much more than they ever have. I mean, you know, the Fed doesn't, didn't used to increase its balance sheet by $4 trillion. And now, that's commonplace and huge fiscal swings as well. So I think macros, you know, certainly doing a lot of the driving in recent years.
Geremy: Exactly. While I do often fall back on that, you know, I'm a big believer in security selection, and obviously a big believer in, investment managers that concentrate on security selection, I think, now more than ever, macro is impacting things. So on that note, let's talk a little bit about Alger. So, you work for Alger. So what is Algers specialty? And what do you think Algers advantages in in in the portfolio's that you offer?
Brad: So Alger is a growth specialist. We were one of the Fred Alger, who founded the firm in 1964 is kind of one of the pioneers of growth investing. And really, you know, before there were categories in the Russell style indexes which date back, you know, to the late 1970s, Alger had been doing it for quite some time. So, Alger is a growth focus boutique. That's all we do. And, you know, the advantages, I think is that Alger has a long history of understanding growth and the impact of disruptive innovation, and understanding who wins and loses from change and what that can mean for stock prices. So I think part of its in kind of the experience, part of it is in that philosophy and looking for change, because where there's change, there's more opportunity. And more opportunity means that the more skill you have, the more you can outperform. I actually say, and I'm borrowing this from an old colleague of mine at Credit Suisse, Michael Mobis, and that outperformance is skill times opportunity. And most people think of you know, when most people pitch their asset management capabilities, it's mostly about skill is what they pitch how good our people are. And clearly, that's a big thing at Alger, but the philosophy which drives the opportunity, where to go fishing, we know where might the fish be biting, where can you really outperform, that's really important. So an area like technology, you know, broadly speaking, has more opportunity than an area like regulated utilities, there's a lot more earnings, discrepancies and variants between estimates and you can make a lot more money for your clients if you get the right say, social media stock, correct. versus getting the right regulated media stock, correct. So I think part of its in the experience, part of its in the philosophy and of course, part of its in the scale and using proprietary research.
Geremy: That is what has always resonated me with Alger is A.) that your strategy is based around change. And that when there's change, there's winners and losers, not change doesn't just blow up a balloon and make everybody a winner. Some people are big losers. And so you can take that as, Hey, I just want to avoid the ones that are going to get hurt by this change. But you could double up on it and say, well, I really want to be in the opportunities that are created by this change. And that those are some of those are big fat pitches, and you're able your portfolio, at least this the spectrum portfolio that is able to more focus on those.
Brad: Yeah, I mean, you know, just like one of the easiest things has been over the past decade, or I shouldn't say easiest, but most impactful things is, you know, ecommerce versus brick and mortar retail, there's been a huge divergence, you know, between the two groups in terms of fundamental and obviously, stock price performance, but, you know, if you were taking a passive approach, and you were just buying the s&p 500, or broader index, you get a lot of brick and mortar retailers that have had, you know, a very tough decade. So, yeah, it's certainly important, not just who wins, but avoiding who loses.
Geremy: So that a good segue. So it's been a decade or more of constant and large change. And, growth stocks have, you know, absolutely dominated performance of other assets, right, but like value stocks, and in particular, maybe large growth stocks also have had some sort of advantages here. So this, I think, is a timely podcast because A.) we've got the idea that growth stocks have outperformed for a wide margin for a long time. That is defined the academics and all their value research and I think there's a lot of people banging the table saying this shouldn't be happening. And, and now we have a bit of a bit of a turnaround here in the marketplace is creating some volatility, which is exposing, you know some of these growth stocks. And so I think this is really timely, this is a good subject to get into, right. And so let's start with something really simple. And then we'll drill down. So let's start with just the simple definition of how the market and indexes and asset allocators defined growth and value.
Brad: Right, well. So everyone defines it a little bit differently. But suffice it to say, there's one company that really matters most in terms of its definition. And that's Russell, because there's over $4 trillion indexed to or invested in the Russell style indices. So you know, they're most the Alger benchmarks are, by and large Russell style benchmarks, and most style specific managers are based on Russell and most people haven't dug into this. But Russell has a pretty simple formula for defining growth versus value. There's, three pieces of it, but the largest piece, and the piece that I think is most consequential to our conversation, is actually price to book value. That's 50%, of how they divide growth versus value stocks. And unfortunately, it's leading to some I think, undesirable outcomes.
Geremy: Yeah. So we're talking trillions of dollars here, where investors are simply saying, I want growth or value. In my definition, my line in the sand is heavily dependent on this variable called price to book.
Brad: Yeah. And, you know, in fact, sometimes, you know, I hear I get the pushback that, oh, you know, we're invested with the value manager, and they don't they don't invest in price to book at all. They're still, you know, totally not relevant for me. And my rebuttal to that, or what I point out is that most managers, at least, that I talked to, certainly we have some managers who are completely benchmark agnostic, but by and large, most, obviously, if you're investing in the passive indices, it's obviously very relevant how the benchmarks defined, but even if you're an active portfolio manager, you're generally over under weighting relative to the benchmark, or at least you look at the benchmark. And so if the benchmark is really flawed, you know, then you're, and you're benching yourself to that with active over underweight then then arguably, your weightings are flawed. And so I think it is impacting a very large degree of the market trillions of dollars.
Geremy: I think, the 4 trillion number might even be understated, because, you know, indexing is probably never been more popular. Last year was just a huge year for ETFs, which by default, are mostly indexes. And when people are making these decisions to index, the security selection is left to a formula. So for example, if you want to invest in emerging markets, and you just buy the emerging markets index, you're just buying the securities that MSCI tells you to buy, like just a formula, nobody's doing any analysis on it.
Brad: That gets it to even more problems because either generally market cap weighted, which leads to a momentum issue, you know, and, you know, you had very big problems, both with the financials waiting before the global financial crisis, over a decade ago, and then back in the technology waiting back before the tech bubble of 99-2000.
Geremy: Yeah, so now we find ourselves now where indexing is extremely popular. And here in the US. There's these definitions that we heavily use of growth and value in this formula that is heavily based on this price to book. So what is wrong with the price to book definition, and how it's used.
Brad: So the concept is like this Nobel Prize winning concept that I won't quibble with the concept at all, of course, just to refresh, you know, for your listeners, what the concept is, is that when a stock is cheap, relative to its book value, which is assets less liabilities, you know, its net asset value, that that means it's kind of cheap, relative to its earnings power. So for example, say you had, you know, an automobile manufacturer, and its earnings were very depressed, maybe because there was a recession, and people weren't buying a lot of cars, or because the type of car that they were producing just wasn't in style. And so the sales are depressed, their earnings are depressed, and the stock price is, of course, depressed. But one thing that doesn't change is the steel and the cement that's in the ground that can produce all these cars that sits on there on the balance sheet. So as the stock price goes down, the sales go down, their earnings go down, the price becomes cheaper relative to those assets. And so value investors have typically looked and said, Well, you know, I know that like this type of company isn't maybe producing a lot right now in terms of sales and earnings. But I see that there's this factory that can produce x amount of cars, it can generate a lot of sales and earnings, and ultimately it'll come back into the economy will come back or the company will figure it out. the right design. And so they're buying a cheap to their earnings power. Ultimately the company figures it out or the economy recovers, the sales and earnings go up and the stock price goes up. And that has worked for a long, long time. Except for it hasn't worked over the past several decades, and is getting worse and worse. In fact, in 2021, the price to book factor low price to book factor underperformed the broad market by 42%, which is a stunning number, and it's the worst in history. And so that begs the question, well, what's going on with this fantastic concept? Why is it no longer working? And the answer is that in a nutshell, is that accounting has failed to keep up with the changing nature of the economy. So what you've had over the past 40 years, you've had a dramatic increase in the investment in intangible assets. These are things like research and development, on software, new drugs, advertising, branding, and investment in human resources, all these things that you can't touch or feel, but are clearly assets and help produce sales and earnings. The investment in the economy wide is more than triple over the past several decades, while the investment in tangible assets, relative to the total has declined. So you know, you can think back to the 70s and 80s leading companies, you know, had a lot of manufacturing plants steel in the ground, as we mentioned before, or even a retailer with a lot of inventory. So that was a tangible based asset model. Today, obviously, if companies like Google and Apple, where they're much more intangible asset focused, the search engine algorithm on Google is not on the balance sheet, even though they've spent obviously billions and billions of dollars developing it. So what's the problem with this. Well, the Financial Accounting Standards Board in its infinite wisdom, basically tells the companies to expense all of this intangible investment, at least when it's done organically rather than capitalize it. So when you expense something, you basically just write it off and say, oh, you know, I spent all this money on r&d and software, and I'm going to expense it. When you capitalize something like you spent take the same amount of money, and you put it in a building, you might expense it, capitalize it, which will lead to expense over 10 or 20 years. So you only recognize, you know, 10 or 5% of that investment in depreciation on your income statement. And it sits there on your balance sheet. Whereas when you expense it, it's missing from your balance sheet, and it completely weighs on your earnings. So very distorted picture of the balance sheet and essentially, now low price to book companies, instead of being these companies that are cheap relative to their net assets or their earnings power. They're really just less innovative, more tangible, asset oriented companies. And companies with higher price to book are more innovative, more based on have business models more based on intangible assets. And so you're really investing in less innovative companies rather than cheap companies in low price to book and that's why low price to book has been such a terrible performer in recent years.
Geremy: That is such a just groundbreaking concept for me. And then, and it really synthesizes this sort of thing that I think a lot of us are feeling, which is I know that Google's an incredible company. And it's just amazing. And I know that there's like a, I don't know, a tire company or something that's very staid, and very non innovative. And, when I think about investing, I think about investing in companies like Google, I don't think about investing in companies that are staid and not going anywhere, maybe falling apart. And so it is amazing to me how you just put that right, that the definition might be the problem. And so that definition so what you're saying then, is that growth is the reverse of this, let me make sure I got this right is that because intangibles are not capitalized, that leads to growth companies having lower earnings than they should and a higher price to book and therefore the PE looks always higher, much higher. And if they capitalized all this r&d and innovation and patents and all these things, that the PEs on these companies would look a lot more reasonable. And you'd have higher earnings, the actual realized earnings would be even higher than they already are. Is that correct?
Brad: Yeah, that's definitely true. So there's you know, there's Multiple implications, there's valuation issues, on PE and price to book which create, I think huge asset allocation issues. There's also the style classification issues that we started with. So there's a gentleman by the name of Brook Labs, who's a professor of accounting at NYU. And, you know, he's written some great stuff on this, he wrote a whole book called The End of Accounting, which, you know, if you're, if you're a nerd, like me, or you want to fall asleep, one of the two, that could be very useful. But basically, in his research, what he finds is that if you did indeed capitalize all of this intangible investment and treated as an asset, which I think we all know, intuitively that it probably should be, in fact, FASB, I think it's going to change their mind on this, we can come back to that later, if you did that, you'd find a couple of really interesting things, one, you'd find that a huge percentage of the companies in growth would become value companies, and vice versa. So there will be huge amount of change in what you thought was value, growth and what you thought was growth value, so it will all change. The second thing that he found is that while price to book I just told you, it's been a terrible performer, if you actually capitalized these intangible assets, put them in book value, and then started investing in those companies with low price to book value with the correct assets, you'd find a quintupling in the returns for the price to book factor relative to the market. So obviously, something is broken. If you can fix it and really increase the returns, then something's broken. So yeah, it's very interesting research.
Geremy: So it's just mind blowing to me. So I'm just going to get back to the big picture point here is all these allocators and indexers. And strategic investors are defining their portfolios and investing all their capital, where the linchpin on this definition between growth and value is a what looks like a flawed measure. It's just mind blowing.
Brad: I think that's definitely true. And by the way, you know, just to kind of prove this to you, and just give you a very simple statistic about what's been driving this, like, if you're ever curious, like what's driving, you know, the value performance relative to growth, there's over a 90% r square, which is extremely tight means, you know, how much one variable is influencing the other between the performance of price to book which I told you has been abysmal, and the value versus growth performance. So if you looked at the Russell 1000 value versus the Russell 1000 growth over the past decade, there's this huge correlation with price with price to book and so as long as that is structurally broken this accounting issue and price to book underperforms, which I believe, you know, it won't get fixed for a long time, then I think what you're looking at is structural value underperformance versus growth, even though I know recently in the past few months, it's been values done pretty well, I think it can overcome the structural problem. And this is only one of two structural problems, I see.
Geremy: And now, so this, this is just a huge problem. And so now you have a marketplace where growth is having a, you know, stocks go up and down. And if they go up, if they, you know, if say growth stocks get a little ahead of themselves, they're gonna have a pullback. But basically the street or the mind of the market is like, oh, no, this is values time now we're going to get a decade for value and what you're implying is they the the approach, or the definition, which nobody's even thinking about is flood.
Brad: I think, I think people don't really know when they think about value, what they think about is different than what they really get. And that's a big problem.
Geremy: It's amazing. So, we're going to move on to another topic here, because we could probably keep going on this. And I do like to drill very narrow, deep holes. But let's go to another topic. So another advantage that's often stated, for growth, stock investing is innovation. And I think someone famously said in the 20s or 30s, maybe that everything that can be invented has already been invented. And obviously, that's not true, and so, innovation, you wanna, you want to talk about innovation as a driver of growth.
Brad: Yeah, normally, you know, I think I start with this, there's one very big picture. illustration of why innovation is the most important thing so you know at alger we actually I said I do macro in the beginning. But at Alger, we don't really focus on the traditional macro that you see in you know, on TV on CNBC, or in the Wall Street Journal or what have you. Because we don't think I think that these shorter cycles, like the central bank cycle, or the political cycle election cycle, the economic cycle, we don't think that they drive wealth creation over the long term. We think innovation drives wealth creation over the long term into we're really more focused, as you said at the outset of, you know, who's gonna win and lose from change, and where's their innovation and what is it doing? So, example I like to give is the example of artificial light, obviously, artificial light is something that we all need to utilize to work etc, when the sun goes down. It's an illustration that shows how important technological innovation has been and why we live so much better than our grandparents. So, in 1800, the method the technology that we use for artificial light was a candle metallic candle is made of animal fat, and want the income from one hour of work. Using that technology, that candle could buy us 10 minutes of light. So you got 10 minutes of light from the income from one hour of work using that technology in 1800. Later in the 19th century, you know, think Little House on the Prairie type timeframe, the kerosene lamp came on the scene. And the income from one hour of work using a kerosene lamp in 1880 could buy you about four hours of light. So the technology change and same hour of work. But now instead of buying 10 minutes of light, you can buy four hours of light, then the modern kind of light bulb came on the scene in the mid 20th century 1950, the incandescent bulb, want the income from one hour of work or purchase 500 hours of light using an incandescent bulb. And then if you're like me, you're probably replacing these incandescent bulbs all around, you know, your house or your apartment, what have you with LED bulbs. And LED bulbs are another leap in technology, in the income from one hour of work using an LED bulb can purchase 13,000 hours of light. So same same hour of work. But the technology shift led you by 10 minutes of light a couple 100 years ago to 13,000 hours of late today, that's over 70,000 fold increase or 5% annual productivity growth. And obviously, none of your listeners on this podcast think about working for light, right because the technology, but a couple 100 years ago, you really had to work. And that was one of the main things that you were working for. So that's what I mean by innovation is the most important thing in generating wealth creation and productivity over the long term.
Geremy: I couldn't agree more. I think in investors, as investors, we do get caught in evaluating the past a lot. And it's hard to look forward. And, but if you just look at the past in a different way, if you just say look at all the innovation that has occurred, and in particular, so right now, we're at a point where, you know, we've had a really good economy, we've had really good asset prices, and you could look at all these things, but to measure our quality of life, but really, the thing that made all that happen was innovation, that's what's made the call our quality of life better, whether we're living longer, we live better lives, we're healthier, we're fitter, where we live in nicer houses, all of these things, were a product of us being able to be more productive and using our brains more by doing less, like physical labor. And the innovation is really what has, I think just enabled our brains to expand and just do amazing things.
Brad: 100% but then there's, one really important point that they need to digest with that, which is that innovation is speeding up. And yes, innovation is so powerful, but it's actually getting faster and faster. And the illustration I use that I think, you know, your listeners are probably familiar with, to some extent is Moore's law, which tells you that the number of transistors on a chip will double roughly every couple of years. Now, when Gordon Moore wrote this paper in 1965, there were 64 transistors on a chip. So there are only been six doublings. But in his infinite wisdom, he knew that it was gonna, you know, continue to double for a long period of time. What this acceleration has meant is that today, the iPhone that your listeners are carrying around in their pocket has roughly 10 billion transistors in it. So we've gone from 64 transistors 10 billion transistors, that is not linear growth. accelerating pace of growth. And we actually find this not just in computation, but in information storage, like hard drives and information transmission, like fiber optic cables, even in wireless telecommunications. And so innovation is really accelerating. And that's why I'm so confident in the future being really good. I think the future also be hard to understand. And I've a quick story if you have time for about how our brains don't think linearly, but it's really this whole thing is very feel good story. And I think very optimistic I, which I know is in contrast to everything, you know, you read and seeing the news.
Geremy: No, I want to hear it.
Brad: So there's just this little story about a game that was the precursor to chess was 13th century Persia, the game was called Sha Mach, which literally means dead king. And the story goes that the, the inventor of the game was the king's, Chief Counsel, and advisor. And, you know, the game had 64 squares, much like a chessboard, and, you know, the king love the game. And he said, it was, you know, it's great for entertainment was also great for strategy. And he offered, the chief advisor came up with the game, anything in the kingdom for award in the advisor, you know, said he just wanted one grain of rice for each square, he came, he said, Come on, this is a fantastic game, you know, I think it's really gonna do wonders for the kingdom, you could think of something better, we have jewels, we have riches land, you know, pick something better. And the adviser said, no, just I just want one grain of rice for each of the squares with the stipulation that doubles on each square. King thought, well, I don't think you know, what you're asking for, you know, that doesn't sound like much but fine. So be it so instructs his man to bring, you know, one one grain of rice for the first square in the first day, then two, then four, then 8, 16, 32 on and on it goes. Well, the King began to get worried because the grain the bags of rice are getting heavier and heavier as the days and pieces on the board squares on the board progress. In fact, the first half of the board is 220,000 pounds of rice works is that each square is more than the sum of all the rice that's come before it. So the next piece, the next square, right after the first half of the board is itself more than 220,000 pounds of rice. Anyway, when you're done filling up the board, it turns out that it's equal to three times the annual rice output of India, or more mass larger than Mount Everest. So essentially, from understanding this exponential growth, the chief adviser has stolen the kingdom from the King. And if you're like me, you know, you had absolutely no idea how much rice would be there by the end of the board, because our brains think linearly, not exponentially. And so that's, I think, what will happen to the future would be very hard to predict, you know, what will happen in 30 years because of this exponential growth.
Geremy: And it's going to be very hard to explain it to people, because I think that we've never lived in an environment like I'd say this in jest, sometimes, you know, 150 years ago, I would have been just cutting down a tree and, you know, milking my cow, and, I would have had a candle in my cabin. And, I would have had no idea about, you know, iPhones or silicon chips or, know, the information to, you know, the world, the web, or any of this stuff that or pharmaceuticals and the genome and all this stuff, right. Nobody would have had any idea. So I guess, in the grand scheme of, or the grand span of human life, the what's happened in the last 50 years is absolutely staggering. And I think it's getting really hard for people to understand it. And therefore, it's probably getting really hard for analysts and investors to even value it. Right, and, what we don't understand were very fearful of.
Geremy: If you if you carried out Moore's law, you know, that exponential growth, what you'd find is that we would essentially have cheap computing power that's more powerful than the human brain in 30 years. You know, and I don't, I don't I don't know what that means for the economy for investing. But I'm pretty sure you know, 30 years ago, people didn't know, you know, what they would be able to do with having all of human knowledge, you know, in the palm of their hand with an iPhone, but, you know, it'll be it'll be very different than what it is today.
Geremy: Yeah. This is fantastic. So I'm going to continue this. And so I did just mention you know, what people don't understand they're afraid of and so isn't all this investing in these businesses of concepts that are really are brand new and innovative and all that isn't that just by most investors proceeding to be more risky?
Brad: Well, so interestingly, I think growth stocks and innovative stocks are less risky than investors perceive. So first off, even with growth stocks relative to value stocks, you know, most of the clients that I speak to, they think, you know, growth stocks are riskier over the long term because they traded higher multiples. And of course, they do trade at higher shorthand valuation multiples, although, you know, we talked briefly about why that might not be the best metric to evaluate them. But anyway, ignoring that for a moment, it turns out that the growth stocks over the past decade have a much lower downside capture, which means they go down less in down markets than value stocks. And why is that? Well, I think there's a few reasons. One, they have traditional drivers of risk or kind of like financial leverage, debt, and operational leverage, and I think they have less of both those, they have better balance sheets. In aggregate, they're levered, you know, less than half a turn of EBITda, on average versus value stocks, which are over two times levered, and they have less operating leverage in that they have much higher margins than value stocks do. But probably the bigger issue is that they're more driven by secular market share changes, then changes in the economy. So if you think about a retailer, you know, the difference between growing a GDP growth, that's 3% versus 0%, is the difference between a brick and mortar retailer growing and shrinking in terms of earnings, because it really needs those, those few percent. Whereas if you looked at a company like Amazon, you know, ecommerce is growing, you know, in normal times, mid teens was a lot faster during COVID. And then slow down as it left COVID. But about, you know, say mid teen percentage points, mid teens percent growth, if GDP growth slows from three to zero, and that ecommerce growth slows from 15 to 12. Well, that's not, you know, a big issue for Amazon, it would still be able to grow during that point. So I think that growth stocks are probably less risky on the downside than value stocks are and when we did a study for the most innovative stocks, which, which I think is a is a factor and a characteristic that not enough people are paying attention to. Maybe we get into that later. But when we, when we looked at that the most innovative stocks in the stock market actually didn't have higher downside capture than the broad market over the past decade. I think, because of those reasons.
Geremy: I think you've, you've hit on a very important difference that in risk, right. So the way I view the value risk versus growth risk is, if you're an academic, and you measure all the data, and you measure every weekly or daily or monthly, up and down in the market, you are measuring volatility, you're measuring sort of the ripples on top of the ocean, right. And during volatility, it can appear that value stocks don't go up and down as much as growth stocks might. But risk hits markets now, you know, if you ignore those small movements, risk hits markets now like a black swan, right, like COVID, or like, you know, the financial crisis or September 11, or, you know, some problem with the Russian default or something like that. It's like this big explosion of risk. And, so, often in times of big down markets, growth stocks are viewed as a point of safety. Because they're just they're their business models have a longer trajectory, and they're less cyclical. And so I think the risk that the way I explained the risk is, is do you want to lower your standard deviation, or do you want to minimize your probability of total loss Right. So Google, I don't think Google's price can go up and down like a Yo yo, but it's not likely to go out of business in the next calamity, right. But a brick and mortar retailer can just go out of business. And then it's permanent impairment of capital. So it's permanent impairment of capital versus standard deviation. I think people are confused on what that is.
Brad: Yeah, I think that there's a big risk of obsolescence in a lot of the value stocks, you know, again, more tangible based businesses and evolving less, probably having less innovation, but you know, one of the classic examples, you know, would be like newspaper stocks. years ago, they certainly look cheap, but the fundamentals eroded very quickly. And so what what looked like a value stock was in fact a value trap, you know, melting ice cube if you will, and Similar thing has happened in brick and mortar retail. And, you know, we think that might be playing itself out in a lot of other areas of the stock market. You know, all you really have to do is kind of look and see where Amazon is, is pointing its tentacles. You know, there's a lot of disruption potentially, in healthcare. There's some potential disruption in logistics, business to business. You know, there's a lot of areas that I think people think, are value which they deemed to be safe. But that could be at risk from disruption.
Geremy: Yeah, so melting ice cubes is exactly the exactly a fantastic example, the longer some of these value businesses stay in business, the worse their, their opportunity set becomes, because they're on the wrong side of change. And so speaking of changing the obvious example of Amazon versus retailers, which everybody gets the, someone very wise at your firm, many years ago, when I was talking to them, and I asked them, well, you know, you have almost 8% of the fund in Amazon, do you feel like that's risky. And this wise, portfolio manager told me that, I wish I could have more. And that was like, 10 years ago. I just thought I'd bring that up. So alright, so innovation, right, being on the right side of change, extremely important. So can you measure innovation, so we measure, you know, we've talked about price to book right being this measure of value, and kind of the problems with that, but we do we offer, we measure growth versus value, we measure size, we measure, we measure quality, we measure momentum, and these are factors are considered, they're largely considered factors that drive performance of either an asset class or managers. And in so can you measure innovation?
Brad: Well, it's funny, we we commissioned Greenwich Associates, which is kind of like an investing consulting firm, to do a survey of investors. Last year, they interviewed 138, key decision makers in the US at over 100 different financial institutions overseeing assets in excess of $18 trillion. And what they found was that people in general, investors or professional investors, believe that innovative companies would outperform 95% of the most innovative companies will outperform 79% said, innovation is really important in portfolio construction. And by the way, the majority of those that whose became more important over the past couple of years. So really important on the one hand, but on the other hand, 64% of them said they don't designate a specific part of their portfolio for investments focused on innovation. So they thought it was important, but they weren't actually investing in and I think one of the reasons why they weren't investing in is because when when Greenwich asked them, how do you, you know, define innovation? What, what's the best proxy for. No one could really agree. You know, the biggest answer 36% of folks said, r&d as a percent of revenue, but you had answers like 11% of people said stock based comp 9% said patents 17% said other 27% admitted that they just have no idea. So I think I think it's hard to measure it. I mean, I and algebra, have our own ideas about how to measure it. But I think for investors, it's not that obvious. And I think that's causing people to not allocate specifically to it, even though they kind of wish they could.
Geremy: Yeah, so maybe some product designer of ETFs is listening to this. And they're, going to design an index ETF of innovation. So and then it'll become a factor and then, and then everybody will want that factor in their portfolio. So, but that's just a brilliant thinking. So really, what is the driver you know, this innovation thing is just so important. And I believe it's, it's pretty missed.
Brad: So we don't think there's really one way to define it. I mean, we've looked at a couple of different pieces. And interestingly, they all have, I think, strong, like statistically significant performance. And I'm not saying that a particular factor even like innovation would always outperform although I do think it's interestingly, you know, we talked in the beginning of the conversation about how price to book has been the worst performing factor over the past decade with this abysmal you know, record recently, the mirror images image of that, and I think, I don't think it's coincidence is been innovation like defined as r&d as a percentage of revenue, because that's of course the intangible based, measuring the intangible base factor like r&d has outperformed while the tangible based factor like book value has underperformed, in fact, the top quintile of r&d relative to revenue, outperformed by 1.2% annually over the past 30 years. And 3.9% Over the past decade, and 5% over the past, sorry, and 7.3% over the past five years, even though it had a rough year, last year. So it has produced really strong returns. And maybe just as importantly, the worst quintile of r&d, those companies that invest the least in r&d have underperformed over the past 30 years, and annually and by 3.2%, over the past decade. So there's been a big spread between the most innovative and the least innovative and the most innovative outperform the broad market. And by the way, when I say the broad market, we calculated equal weight and sector neutral. So it's not like it's just all because of Amazon or something like that. Yeah, we find that it's, you know, across sectors. In fact, the largest consumer discretionary has more of a signal for this factor than technology does, but you also see it in industrials and other places.
Geremy: So, this innovation factor can apply to any industry any, any sector, any industry.
Brad: Yes, it's across the market and across market caps.
Geremy: So when you when you just mentioned outperformance just for one question, I think it's probably going to come up is versus what would that be versus the s&p equal weighted or market cap weighted?
Brad: It's the broad market is broader than the s&p 500. We had we had an empirical research, one of our research partners do this. But I think of it as a broad market, equal weighted and sector neutral. So not just large companies,
Geremy: Excellent. And across different sectors. It's not just it's not just a growth thing. It's even in the value sectors this worked.
Brad: Yep, yep. across across many different sectors.
Geremy: That's pretty amazing. Okay, so I'm having a great time. This is by far the one of the most interesting conversations I've had in a long time. And so we are butting up against an hour here. And, that is, I've been told that that is the tolerable limit. But although I could go on, so and so I, quickly recap here, right. So you know, growth, stock investing is not just a definition of how some index company defines growth versus value. Now, that's effectively how empirically how it's used. But growth stock investing is so much more than that. And and that the current measures that are used to find growth versus value where people are allocating trillions of dollars, really has a huge flaw. And that is hindering what looks like the PE of growth stocks and their price to book and that the indexes would be defined totally differently. And the performance of them would be totally different. And really, if we dig under the cover of what's behind this growth, stock investing outperformance its innovation. Yeah. So, so, accounting, innovation, and this sounds to me, like good old fashioned research, as opposed to formulaic, simple exposures of indexes right. So what I'm taking from this is, is I don't feel like I want to index growth. And I don't think I want to index value.
Brad: It's some unintended consequences, especially these days, it's arguably the intention is becoming greater and greater as as as innovation becomes more important.
Geremy: So, Brad, is there anything we missed here?
Brad: Well, you know, you're on some of my favorite topics. So so I can talk for a long time about this. Well, we did we did miss kind of the asset allocation story, which I think is probably is no bigger topic to talk about, then, you know, our stocks, expensive or cheap and relative to bonds and all those things and, you know, the way most people come out that is they look at something like a price earnings multiple. I mean, of course, there are many different ways of looking at it, you can look it up so called Cape you know, Shiller, you know, looking at the average of 10 years and a p but anyway, most people do do something similar to that. And and I think that these accounting and innovation issues that we've talked about, really make that a very flawed approach when you look over the long term. So you know, I mentioned that There's been this big shift over the past 40 years with intangible investment. And I said it impacted the income statement. Well, if you just looked at if you looked up the PE of the s&p 500, right now, when you compare it to some average over, you know, 1020 3040 years, you'd say, Gosh, it's really expensive. And maybe I should lower my equity allocation, you know, what have you. The problem is that you're not looking apples to apples with, you know, 1020 3040 years ago, because the more companies invested in tangible assets, the more their investment is recorded on the income statement, the more it depresses the earnings. How could you get around this, you just look at cash flow, because obviously, cash flow doesn't care anything about accounting or with the FASB says. And so, if you looked at free cash flow multiples, relative to history, you know, if you looked at, you know, say, say, versus the past 20 or 30 years, what you'd find is that free cash flow multiples are actually in line with their historical averages, whereas P multiples are significantly higher than their historical averages. And again, I think the only reason that could be is because companies today are generating more free cash flow per dollar of income. And the reason for that is because the earnings are getting more and more depressed, because more and more of the investment is recorded in the income statement, you know, it's neither good nor bad. It's just in the 1990s, the s&p 500 produced 75 cents for every dollar 25 cents in free cash flow for every dollar of earnings. Today, it produces about $1 of free cash flow for every dollar and earnings. And this should be, you know, make sense to you, if you just think like, you know, an industrial company, almost certainly produces much less in free cash flow than it does in net income. Whereas if you looked at a software company, it would probably produce more in free cash flow than in net income. And so that dynamic is happening across the whole stock market. It makes Pease very hard to compare over time. And it makes those people who think that the stock market is very expensive. I think I think it makes the stock market actually cheaper than it appears.
Geremy: And yes, so that's incredible. So I'm going to maybe put that a little bit in my language, which is we're no longer an industrial nation, nor is the first world an industrial world. We are a services based economy, right. The majority of the profits are the more profitable areas of the economy are service based and service based companies have a tendency to have intangibles. And so those intangibles on the income statement are making the look too low. So if the E were no more normal, the market wouldn't look completely overvalued.
Brad: Yeah, in fact, we estimate that the if these intangible assets were more correctly capitalized, that earnings would be over 10% Higher. And instead that would change the valuation picture significantly, especially when you start, you know how low interest rates are, you could certainly make the case for equities being much more attractively valued than I think the overwhelming majority of, of investors think there.
Geremy: So that's, again, just as an asset allocator that's just pute a humongous piece of information right there. And as you know, most of the thought leadership and asset allocation is based around PE or earnings yields. And then and those being predictors of future returns over time. And if you wait long enough, you get it. But it does appear that the s&p 500 for you know, since the mid 90s, has maintained a much higher PE than almost every other point in history. And it stayed there. And so just because the PE is high doesn't mean the markets going to crumble. And now you have also uncovered the reason why the PE is high is if as we've moved to a service based economy there's way more intangibles and they're on the wrong side of the of the financial statements.
Brad: Yeah, that that and interest rates I think are the two big drivers of you know, these higher shorthand valuation metrics like the
Geremy: Yeah, that's fantastic. This is this has been one of my favorite podcasts so far. I'm, sufficiently surprised and I'm not easy to surprise. So Brad, I really appreciate you being on here. I think we need to somehow call this to a close. I do have like six more questions that we haven't gotten to but these have been so good.
Brad: Well, if you if you want to go on and leave someone on the cutting room floor, I don't know, if you do you do an extra for your listeners, or maybe if you splice it in, I'm happy to answer. You know, a few more questions.
Geremy: Well, let's keep it going then. Okay, so one of the other so, you know, the big obvious thing hanging out there as growth stocks are so expensive. And the markets now showing that right so what so what do you think of that statement that hey, growth stocks got ahead of themselves, the PE's are so high. And now we're having volatility, you know that what is it something like 30 you know, I don't know what percentage of the NASDAQ is down 50%. But there's quite a few stocks that have been really hurt here. So do you want to comment on the on the latest market volatility and growth stocks.
Brad: So, you know, I think, I think that there were certainly some areas of the market that were expensive. And frankly, I think that there still are certain areas. But I think that the stocks that have been hit the most, which I'll call the longest duration assets are those with the cash flows furthest in the in the future, maybe partially over the, you know, worry of rising interest rates, those stocks, I think, are now historically cheap. So certainly on a relative basis, and probably on an absolute basis to once on a relative basis, the s&p 600 growth. P multiple, for better or worse, is trading at a large discount over 20% discount to the s&p 500. That is the largest discount in at least two decades. The last time it was close to this low was 2001. In the five years ensuing. From that point, small cap growth went on to outperform by over 50%. So I really think that that part of the market has been probably punished too much at this point. And I think there's some really attractive values. Even on an absolute basis, it's pretty cheap. But of course, interest rates are much lower today than they were in the past. And I think that's one of the main things that makes the stock market look cheaper. Besides the accounting thing that we talked about before, I think, you know, a lot of listeners may be surprised to hear that relative to interest rates, the stock market is actually attractively valued to history, or at least in line, not expensive. So on a fee basis, yes, it's depending on exactly how you're looking at it, you know, 15 to 25%, higher than history, you know, with a 20 times B versus like a 16 times, historically. But, but when you look at the so called equity risk premium, which is how much investors require over and above the risk free rate, how much they discount those future cash flows back by that, you know, at least like say, the way Goldman Sachs estimates estimates it for the United States is 5.1%, which is actually above the 20 year average of 4.9%. Above means cheaper. So, you know, an easier way to say this is that the earnings yield on the s&p 500. You know, which if the multiples 20 times that means it's a 5% earnings yield is over 300 basis points higher than the 10 year treasury. And if you looked over time, through most of history, those numbers would be much more equal to each other. There's very little spread. So stocks are, you know, very cheap relative to bonds and interest rates. And so that's another thing to start with.
Geremy: I think, I think fixed income investments have they're in a real weird corner right now. That's probably a whole nother subject. But that is that's an it's a nice positive for the overall market. But and as you mentioned, the price to free cash flow looks normal. And the it's amazing, the small cap growth area, the market looks as cheap as it does, that there's something that I think a lot of people haven't noticed that there's been the of the smaller cap growth companies, there's been a huge price adjustment here.
Brad: It's a product, it's a product of two things, just to be clear, it's a product of yes, the prices have come down, certainly on a relative basis. But the earnings have actually been pretty good. And if you look at the next 12 months estimates for the s&p 600 growth a year ago, and how much they've grown now, they actually have grown far in excess of the s&p 500 earnings estimate. So you've had price underperformance with fundamental outperformance that's what leads to very large valuation compression.
Geremy: So I've been so I think this is a related topic to this. This is sort of the opposite of this. The s&p s&p 600 growth, which is a very small subset of the market. The opposite subset of that might be not not the exact opposite. That would be the larger cap growth and and do you want to comment on the concentration of the big names in large growth indexes in and how do we get around that issue and isn't even an issue.
Brad: So, you know, the s&p 500 is, is as concentrated as it's been since the 1960s. And the Russell 1000 growth is the most concentrated effort, you know, the top handful of names top five names in the Russell 1000 growth account for about half of 48% of the of the overall index. And I think that is problematic. Because, you know, one, when you're investing in index and trying to get diversification, you may not be gaining as much diversification as you want to, because it, it makes it the drivers are very concentrated. And we all know that companies do turnover over the long term, if you looked at the, you know, the leaderboard of the 1960s s&p 500 market capitalization, it would look very different than what it is today. And so, so we do think a lot of those companies are probably not the most attractive places to allocate capital. We're generally underweight, you know, those, those very largest companies in our large cap portfolios. You know, Facebook, or meta is a good example, which we've been underweight for significantly underweight for some time, and just had some very disappointing earnings. Because, you know, once you get to a sufficient size, the law of large numbers catches up catches up to you, you know, built millions of users around the world on the platform. There's only so far you can grow until that next leg, you know, maybe the metaverse kicks in, but we think it's a long time for that. So. So yeah, I think it's problematic. And I think it speaks to the advantages of active management where you can, you know, allocate differently than the benchmark does, which has a mindless, as you said, you know, algorithm.
Geremy: Yeah. And I think what, what has kind of happened here is, it's been, you know, anytime you have a long outperformance of a certain sector of the market, you get a lot of people running to that corner of the canoe. Right? And and the more people that buy those indexes, the bigger the problem gets, because the proportionally larger companies than the other companies in the index. Now, did you? I saw a headline come across my phone and and does this resonate with you with that, that Facebook lost on when it went down 23% or whatever went down, it lost $200 billion in market cap. And that was more than the 450 smallest companies in the s&p 500. Which are in total market cap, which just blew my mind. I guess I can't verify that now. Because it was vapor on my phone. It just kind of moved on up. But did that. Yeah.
Brad: I should have said earlier that it's the top the top 10 in the Russell 1000 growth to the 40% against top five. But But yeah, you know, you have very, very large market cap swings, unprecedented obviously, in in dollar size. And, you know, I think it's also important to look at how the, you know, the equal weighted market is doing and, you know, if the if when the market becomes very narrow, that is typically not a good sign based on history. And, and so we have seen a narrow market recently.
Geremy: So, to summarize this valuation and market performance piece of this that we're talking about. The, the market volatility that's occurring right now is uncovered some opportunities, as well as the concentration uncovers opportunities, right. So if there's too much money and too few securities in the other securities, by default, maybe are a better opportunity. Is that safe to say?
Brad: Yeah, you know, we saw like, kind of, it's kind of a, like a golden age of active management after the last time that concentration, the market became so concentrated, which was around 2000. And after that, it set off a really good run for small cap stocks. And if you look, and again, I'm using some of the work that Michael Mobis is done here. But if you look at active management, relative performance to the benchmarks over time, there's a pretty strong correlation with the relative performance of small caps to large caps, and that's because active managers generally skew smaller. Yeah, so if the market is going to become if it's become too concentrated, and it's going to start to move away from that, and small cap is going to participate more than that will be good for active management. So all those things could be coming together a lot 20 years ago.
Geremy: I couldn't agree with that statement more. At least that's how I feel Well, good, well, good. So final thing here are the accounting problems that define growth versus value and give growth that make growth look more overvalued than it really is, but are tailwinds for growth. And this innovation factor, are these structural in our marketplace, are these sort of just paper, they'll just go away?
Brad: Well, the the certainly the the accounting thing, the accounting issue, you know, can be changed by one of two parties, that can be changed by the style benchmark providers, you know, defining growth versus value differently, that could change things. But while I have seen you know, a couple of those folks, follow me on LinkedIn, and maybe pay a little more attention to this issue. I haven't haven't seen anything from them. The other one that is probably even slower moving would be the Financial Accounting Standards Board. But I would note to the FASB did reach out to myself and others, with a survey asking about the importance of intangible assets. And would it be more important if there was more disclosure on intangible assets. So I do think that they may or may come around. But the last time I heard of something like this was lease accounting, when they were going to put capitalized leases on the balance sheets. And that took I think, you know, better part of a decade, so wouldn't hold my breath for that. You know, then the second piece of innovation accelerating, you know, this is a topic and theme that people far smarter than me who have discussed for a long time, the one I normally like to cite is Ray Kurzweil. He's the chief engineer at Google. A lot of people call him the Ben Franklin of our time, he's written a book called The Singularity Is Near to us plans to update that very intelligent person, obviously, and even as importantly, a person who's really studied, changing the changing pace of innovation over time, and his belief is that innovation is accelerating. And that's ultimately why he believes that the singularity will come because singularity is essentially when technology becomes smart enough that it can iterate on itself, without humans, and there's, by the way, already some evidence, you know, like AlphaGo, was one of the first programs that was able, you know, to effectively learn without human input. But once we get to that point, then I think innovation will be even much, much, much faster than it is today. And so really, you know, I think it's pretty clear that both of those structural both of those trends are structural in nature.
Geremy: They feel like they're structural in nature. And me, I think the index providers, reconstituting indexes would feel like an earthquake equity. With the trillions and trillions of dollars that index, they would just, you know, now, FASB could make a big move here. But then the pace of innovation, absolutely, it just seems like it's hard to even hang on to it. So, those speak to these differences between growth and value. And we I think we've uncovered a lot here. That's not being talked about at all. And, so I think this has been fabulous.
Brad: Yeah, I really enjoyed it. And yeah, happy to come on anytime.
Geremy: Yes, I'd love to have you back. We're probably got to give you a break before we have you back because I could have you back maybe tomorrow. And we'll, finish up on all the other topics we could talk about. But this has been really great, Brad. Everybody again, Brad Newman from Alger funds. This has been phenomenal, enlightening just really just thankful that you were here and I appreciate it. And thank you all for listening. And Brad Have a great weekend.
Brad: Okay, yeah, you too. My pleasure.
Geremy: Thank you very much.
Shannen: To everybody listening, I wish you could see Geremy dance during that
Geremy: You're not supposed to let people know that I did a little dance during that.
Shannen: I thought it was perfect, Geremy.
Geremy: Well, you know, I love Scott Iverson's album of greatest hits of music written for the the enormous subset of, the of my listeners. Investment analysts music by Scott Iverson.
Shannen: It's great. It's catchy. All right. Well, I think there's so much to discuss after that interview.
Geremy: Yeah, I mean, this. That's just, I mean, obviously, hopefully you could tell when I was interviewing him that I was just, I mean, I had read the research. And he's articles about this concept of capitalizing intangibles. And what and what that's, you know, whether you are capitalizing or not capitalizing intangibles, and how that changes the whole structure of the market. And it, it just was mind blowing to me.
Shannen: Yeah, one comment that Brad said that really stood out to me was, people think about value, what people think about value is different than what they get. So, to me, what value means is probably a little different than what it means to you, because you're a lot more seasoned and you understand, like, what the process is, what might happen, what has to happen to get that outcome?
Geremy: Yeah, and so I think, you know, value to each person has a different ideal, right. So some people think Google's a good value at any price, because of the type of business it is. And some people might think, you know, an industrial company is has value, because it's defined by what the category of value is. But so, you know, and value kind of has a connotation, like, we all want to be value investors, right. Why do you want to be a value investor right. So I think they've kind of hijacked that word, but in the modern interpretation of what value is is, is it has to have a definition, it can't just be like, I like to buy investments at low prices, it has to have a definition. And so the market is categorized stocks, based on metrics that simply just say, these are value stocks. And I don't think that investors fully understand the impact of that.
Shannen: Yeah, absolutely. You guys talked about the macro trends are much more prevalent in today's climate. Can you touch on that a little bit more?
Geremy: Yeah, I think that, that in, in probably decades, in the past, business, the success of businesses was a little more independent of the economy, interest rates, the Fed, and Black Swan risk events, right. And but now that we have a very interconnected global investment environment, where we have lots and lots and lots of investors, not just just a very, very few, investing is really an important part of a lot of people's lives. And, and so this interconnectedness, and, and adoption of investing causes sort of more more waves that can occur. And, and then some of the changes that occur like we're experiencing today, you know, the markets having a rocky patch, I made light of the winter of discontent, but it's not really that bad of a risk event right now. But most of this is, is the market's response to fed tightening, where, you know, in decades gone past the Fed might have not influenced stuff as much. So interest rates in the Fed and growth rates and policy, all those things are now impacting markets a little bit more than they used to.
Shannen: Yeah, and I feel like a lot more people are interested in learning more about it also.
Geremy: Yeah, I think I mean, I mean, it. Yeah, like, like printing sample, like, I think in the 70s, the last time we had inflation, I don't think a lot of the population were investors, they just went to work and they paid their mortgage. And sure, if interest rates were up or down, maybe it affected, they didn't have credit cards, they didn't have, you know, loans and all these things that we had today. So when interest rates went up or down, or the Fed did something or when the when the macro environment changed, it didn't really matter to them, because they weren't really investors. And so they didn't have to stay on top things. But today, almost everybody's investor, everyone's got a 401k. Almost nobody saves money in the bank, they save money in their custodial account. And if and you have this overload of information, so why wouldn't you try to catch up and keep up with what's going on? And and then there's this natural tendency that if, if you're informed, and you spent time researching something, then you should do something about it. So it's causing people to trade more as well.
Shannen: Right. So I wanted to touch on value investors, Brad said in 2021, the price to book factor underperformed the broad market by 42%. That's a pretty big number.
Geremy: Yeah, so what he meant by that is if you just divided the market based on just the price to book factor, and just put a bunch of stocks into a box, because they have a low price to book, then you track the performance of those stocks, it would have been 42% less than the overall market in 2021, according to Bret, so if that's your defining measure of value, I mean, I don't think it like, again, back to that I don't think in value in your question, originally, I don't think value investors understand what they're getting, you know, if that's your measure of value, say I'm gonna, I'm going to index value. And I'm just going to take what the index gives me verbatim based on this price to book measure, then I get this basket of stocks, and then the basket of stocks, they don't necessarily each of themselves have to represent a good value, they just called a box value. And those stocks have underperformed, not only last year, but they've underperformed for the last decade, and longer. And by a wide margin.
Shannen: Yeah, you guys spoke about the growth and value and that there's only really one company that really matters most in that definition. There's over $4 trillion indexed to or invested in the Russell style indices. So Russell, he was talking about has a pretty simple formula. And the largest piece to that is that price to book value that we just talked about. And unfortunately, it's leading to some undesirable outcomes.
Geremy: Yeah, well, it so. So yeah, there's a lot in that question, Shannon. So So what's what's happening is most investors are now asset allocators. And one of the basis is of asset allocation is you should divide your assets up into these categories, right. And the categories are defined by in the US by large value, large growth, small value and small growth. And to represent those categories, you need an index, you need a construction of the basket of securities. And then so you need to define how you put stocks in each basket, right. And the main defining difference between growth and value stocks, if you break down the factors of what's driving that is price to book. So simply, they're saying they're drawing a line and saying, every stock with the price to book below a certain amount goes in the value box. And every stock with the price to book above a certain amount goes in the growth box. And then just people just take that for granted. They just go Yeah, that's the way it is. Jeremy, that's just how it is. And, and it doesn't have to be that way, of course, but that's the way it is. And and so when people buy a large value index there, they're simply just buying low price to book stocks.
Shannen: Right. You also said with that, when you guys were talking about that, you talked about the market cap being weighted. Can you explain that a little bit more and how that could lead to a momentum issue?
Geremy: Yeah, so the second thing that happens when you have when you're constructing indexes is that you have to then wait, the stocks in the index, and the stocks are weighted by their market cap. And so what that means is that the if you drew a line in the sand and said every stock below a certain price to book is, you know, in this value box, then you have to say, Well, how do I wait them? Do I equally weight all those stocks in the index, or it is one stock a larger percentage of the index than the other? And so that they do use market cap weighting. So the largest stocks are the largest proportion. Now what happens is if you keep buying that index, those largest stocks keep creeping up, right at index, because the the there's no manager of an index, the money goes in and it proportionally buys the percentages. And so if one stock is 5%, and one stock is half percent, right one stocks 10 times the other and then you put more money in is expanding.
Shannen: Yeah, well, I think we could talk about your interview all day, there are so many great points. But is there anything further that you wanted to mention?
Geremy: I just think it's incredible that there's this arbitrary line in the sand it says a lot of your price to book is below a certain amount, your value and your price to books above a certain amount, your growth right? And then at that formula, that price to book is an accounting measure of a stock right? And that price to book is influenced by whether you are capitalizing your intangibles or not. Right. So So I think it's just a recap what this whole interview was about was like, is that FASB does not allow you to capitalize intangibles. So for example, if a drug company spends billions of dollars a year in research and development to develop drugs, that's expensed against their, their their earnings, so a growth company with a lot of r&d and a lot of innovation and trying to invent things their earnings are unnecessarily suppressed. At the earnings level, they're too low because they're expensing intangibles. But on the value side, if you own a factory, your factory is not an expense, it's an asset. So it's on the books side of things. Right? And then you depreciate that asset. And so it always looks like industrial base companies are value and growth companies are growth. Let me sorry, I'm sorry, service companies growth, right? So then you're unnecessarily penalizing the earnings of service companies. And you're artificially increasing the value of on the book value of value companies. And And that difference is influencing what percentage people invest in what stocks? And it's just an accounting measure? Yeah, it's just a simple change in accounting would change the whole dynamic, how the market is allocated? Trillions of dollars. It's just truly incredible. And so and as I said, I think that would be a big change for the market to absorb. But luckily, you know, organizations like FASB that make accounting rules. Take a while.
Shannen: Yeah, it's not gonna change overnight.
Geremy: Yeah, but but it explains why people often think companies like Google are incredibly overvalued, it's because their book value is unnecessarily low, and their earnings are being suppressed. But if you switch that, they'd have a higher book value, and they'd have higher earnings. And they might look more like a value company, and they might look more investable or reasonable to people. And, and, and so. And so we all know that innovation, we've heard this on the podcast, innovations in Excel accelerating in, we are service based economy, we are our advantages research and development. And these are the companies that are often leading the economy, and they shouldn't be penalized. And so that is really the crux of this whole podcast. So I really loved it, it was eye opening. And hopefully, the listeners got, what I got out of it is that some of this is that some of this stuff is kind of arbitrary. And you don't necessarily want to put your dollars on arbitrary little things that create big outcomes. And so, so I hope, I hope we got people to think about this.
Shannen: I think so.
Geremy: So I appreciate everybody for listening. This long. I thought this subject deserves more time. And again, as I said, I respect long form journalism, I just don't have the time to sit down and read it. So hopefully, this was enjoyable for you. And I thank you for your time and hopefully we'll see you next time. Thank you.
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