Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Behavioral Investing - Interview with Jeff Henriksen (S2 E1)
Join me as we kick off the exciting second season of Not Another Investment Podcast, featuring an in-depth conversation with Jeff Henriksen, the visionary founder of Thorpe Abbotts Capital. This episode offers a wealth of insights into the realm of behavioral investing and market dynamics, particularly within the US small-cap equity landscape. Jeff sheds light on market inefficiencies caused by behavioral mispricings and unravels how he uses those as a tool for seizing opportunities amidst market biases. Gain a fresh perspective on how crowd wisdom can enhance market efficiency and the intricate dance between investor preferences and market errors.
Listeners will be intrigued by our exploration of market extremes and valuation reversals, where we dissect the patterns of systematic behavioral mistakes that create windows for strategic investing. Using Keynes' analogy of newspaper beauty pageants, we unpack how collective biases can cloud intrinsic value assessments, especially under the influence of inflation and fluctuating interest rates. Dive into the concept of the "correction fulcrum" and discover how markets self-correct after overreactions. Our conversation also delves into Mandelbrot's fractal theories, highlighting the potential for arbitrage across market cycles.
The conversation provides a thought-provoking discussion of the interplay between passive investing and active strategies like Jeff's. Understand how passive funds can inadvertently intensify market cycles, presenting challenges for active managers while simultaneously offering strategic openings for those adept at navigating market momentum.
Whether you're a seasoned investor or new to the market, this episode promises to equip you with actionable insights and a deeper understanding of market behavior, enriching your investment journey.
Research links:
- Cochrane, Discount Rates (2011)
- Mandelbrot, The (Mis)behavior of Markets
- Damadoran, Narrative and Numbers: The Value of Stories in Business
- Soros, The Theory of Reflexivity
- Bhaskar & Suleyman, The Coming Wave: Technology, Power, and Twenty-first Century's Greatest Dilemma
- Bernanke, 21st Century Monetary Policy
- Gabaix & Koijen, In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment Podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley. So we're kicking off season two and in season two we're doing something that's completely different. We're going to start talking to really interesting people who play some role in markets and investing. See if we can't get deeper around topics that are very current or that are front of mind or just plain old interesting front of mind or just plain old interesting. As this series goes on, you'll find that I'm going to give you reference to some core episodes that you might want to listen to before listening to an interview, but if you're all set and squared away, then we'll just continue. So today I'd like to welcome Jeff Henriksen to the podcast.
Speaker 1:Jeff is the founder and the portfolio manager for Thorpe Abbott's Capital here in Charlottesville, virginia. They run a very interesting US small cap equity strategy. Jeff also teaches in the private markets program at the University of Chicago Booth School of Business and he teaches for Training the Street. Jeff grew up on a horse farm in Texas where he did high school rodeo and he earned his MBA at the University of Oxford, living in the UK for three years, jeff. Welcome to the podcast, ed. Great to be with you. Thanks for having me. I'm delighted let's jump right in and tell us a little bit about Thorpe Abbott's equity strategy.
Speaker 2:We are focused on behavioral investing, and the way that we define behavioral investing is we are looking for situations in markets where, for some reason, the behavior of the market has caused a group of securities to basically get far out of whack with intrinsic value, and we then utilize those moments to basically invest in a large basket of securities that we believe in aggregate reflect a very large prevalent bias in the market at that time, and we make our money from the mean reversion that will take place in that aggregate bucket. So we're very much a quantitative strategy in that regard. We're not trying to pick individual stocks. Trying to pick individual stocks and I can talk a lot about why I think if you're trying to take advantage of behavioral mispricing, stock picking is a mistake you want to really get exposure to larger behavioral factors, and so what our strategy looks for is it uses quantitative methods to try to find and locate behavioral dislocations and then takes the other side of the trade when we find them and then we make our money off mean reversion.
Speaker 1:What's you use this phrase? Behavioral mispricings, behavioral dislocations? Walk the listener through a little bit more minutely what you mean by that.
Speaker 2:Yeah Well, I think the best place to start in terms of what creates a behavioral mispricing is to understand in theory how should is to understand in theory, how should markets work, and in theory, you know the theory of efficient markets.
Speaker 2:If markets were efficient, there would be no behavioral mistakes and there would be no arbitrage really there. You would basically earn the return that you should earn relative to the risk you're taking, and then we could all go do something else with our lives I could go back to being a rodeo guy or whatever. So if you're going to invest in public markets actively, it must be because you believe that markets are not efficient. And so for us to understand behavioral mistakes, we start from the perspective of why should a market be efficient in the first place? And the way I view that is well. Why should crowds be wiser than the individuals that comprise the crowd? So crowd wisdom to me is kind of the backbone of market efficiency, and crowd wisdom is an interesting thing.
Speaker 2:And crowd wisdom, in a nutshell, the way I look at it, is, if you have a diverse crowd and ask them a question and by diverse I mean a crowd that there's multiple different mental models. Everybody has a different mental model of the world, everybody has different experiences, et cetera, and they all bring that to bear on whatever the question we're asking is. So you have music majors, you have finance people, you've got engineers lots of different people, each with different skill sets, and you ask some question. It could be anything. What does? How many pennies are in this, I don't know, 50-gallon oil drum, whatever, everybody's guess is going to be the right answer, plus some error term, and as long as there's a diversity of mental models, a large enough crowd and this is the key as long as the errors are not correlated, well then all the errors should, over enough guesses kind of cancel out, and what you're left with is something pretty close to the right answer. And this is why—.
Speaker 1:The so-called wisdom of the crowd, exactly.
Speaker 2:And when crowd wisdom works, it's because there's a diversity of mental models and uncorrelated errors.
Speaker 1:So do markets work only because of wisdom of the crowd, and if there is no wisdom of the crowd, markets don't work.
Speaker 2:Well, I think so. My view is, in theory, if markets were exactly as I just described, with no correlated errors, then you would. They'd be pretty damn efficient. My view and I know we're going to talk more about this later, but my view is that you go through periods where they're pretty efficient and then you go through periods where errors get really, really correlated and what makes that happen?
Speaker 2:So the correlated errors in my view happen for a variety of reasons, but largely at the heart of it is shift in preferences among investors, shifts among risk preferences in particular. And if you think about each individual investor, we have a utility function and it could be, and typically it's a utility function in investing. We describe it relative to a level of wealth or, if you want to kind of get into prospect theory, relative to changes in wealth.
Speaker 1:And just to footnote that to remind listeners, right utility curves just describe the combination of things that would make somebody equally happy on the same curve, and if there's a higher curve the combination of things will be different, but on average they will be more happy.
Speaker 2:Exactly. And that curve, the shape of it you know how concave it is really defines how risk tolerant an individual is right, and general theory says that your risk tolerance is going to be different than mine. Of course it is. But and I'm going to back up one second here there's an economist, I think his name is John Campbell. He's a financial economist at Harvard, or he was at Harvard. One of his big things is time-varying discount rates, which we can get into that if you want.
Speaker 2:But what I view and this is why I think you get behavioral shifts is that there's time-varying risk preferences, there's time-varying preferences on the risks that we as investors take. And so when you say, well, what causes uncorrelated or sorry, correlated errors and mistakes? I think when you have an aggregate big shifts in investor preferences and you have that utility curve in aggregate shift based on response to the economic events of the day, initially probably it's justified, but markets are a lot like technocrats they're really good, but then they take things too far and I think what happens is when you get deep into one of these cycles, investor preferences shift too far in one direction.
Speaker 1:Is this what some people call hurting?
Speaker 2:I think it's exactly what it is. It's hurting behavior and I'll give you an example of kind of going back full circle to our strategy and maybe I'll keep it simple strategy and maybe I'll keep it simple A topic that's kind of du jour today Florida real estate. Florida has a huge history of boom-bust cycles.
Speaker 1:Florida is a topic of the day, let alone Florida real estate.
Speaker 2:but yeah, yeah, florida is. So if you ask most people logically, when do you want to buy Florida real estate, I think most people would understand well, look, florida has a history of boom-bust cycles. We're kind of in a boom cycle. Now Might not be the best time to invest in Florida real estate. Let's wait until the next problem du jour happens Florida real estate tanks and then maybe go look at Florida real estate, because why? Well, when Florida real estate really gets ugly, you can get it cheap.
Speaker 2:Florida itself is a very nice, warm place, it's got favorable taxes, et cetera. You can make a reasonable assumption that the cycle will come back. People understand that, I think, pretty well with real estate, because real estate is tangible, they can look at it. They don't understand it as well with public equities, but it's the same idea. And when you have investor preferences shift rapidly, it causes certain parts of the market to become like Florida real estate in a down cycle and it's like this stuff has been left for dead. And to me that and when I first started this I used to think that behavioral mistakes and this gets back to when I say you can't stock pick in behavioral investing I used to think that you could, but what I found is that behavioral mistakes, by definition, need to be systematic right.
Speaker 1:If you're, you mean investing in behavioral mistakes.
Speaker 2:Yes, that's what I mean. I'm sorry.
Speaker 1:Because I suppose each investor's behavioral mistake becomes systematic when it's as highly correlated as you're describing.
Speaker 2:That's exactly right, because you could be biased in one way and I could be biased in another, and individually we're both making mistakes, but if your bias offsets mine in aggregate, it's not creating an opportunity. It needs to be that we're both bat shit crazy at the moment and that drives everything in one direction.
Speaker 1:This is a little reminiscent of the famous quote from Keynes where he describes how equity markets are a bit like newspaper beauty pageants, where the people who are voting aren't choosing the face that they think is prettiest. They're choosing the face that they think other people think is the prettiest. But yes, that's right.
Speaker 2:You're trying to figure out what do I think everybody else is going to like, and anyway, well, when investor preferences shift rapidly, systematically, in one direction, inevitably, initially I think that shift makes sense because they're responding to something, and we can talk a lot about these external factors that do this, but eventually it goes too far. And when it goes too far, if you take the other side of that and you have the patience and the capital that can withstand the volatility because timing is very difficult and you're never going to time it perfectly but ultimately you can take the other side of that and make a lot of money.
Speaker 1:You use the word mistakes and I'm wondering if you mean to imply, like it sounds, that the investors are erring one way or the other. I understand your point about one's risk preferences becoming correlated, the market's risk preferences becoming correlated, either for good or for ill. What makes it a mistake?
Speaker 2:I think what makes it a mistake is not the initial shift. So, for instance, take the current environment today. Right, Small caps are out of favor and we're going to talk about that later, I know but why? Well, that's a whole podcast in and of itself, but I would say largely why is, if you look at the problems of today, it's inflation not coming down quickly enough. It's inflation not coming down quickly enough, the Fed having to raise rates to levels that a pace and to a level that we have not seen in a very long time in this country and, in the market's view, no end in sight to this. So who's hurt most by this? Well, who's hurt most are companies that are cyclical, because the interest rate cycle is going to have a pretty nasty effect on the economy potentially, and companies that have a lot of exposure to floating rate debt that have to refinance in this higher rate environment. So what types of companies are those? Well, they typically are small caps. Small cap domestic companies typically are more cyclical. They typically have more exposure to floating rate debt. Oh shit, they were right in the heart of the storm.
Speaker 2:I don't want to touch those things. I want to own large cap companies that have funding locked in for very long periods of time. That generate lots of cash. That can earn excess interest on the cash, take advantage of the higher rate environment. That have cyclical growth opportunities. That are immune from what's happening in the overall economy. So I'm long MAG-7, short Russell 2000. That's kind of what the market's saying.
Speaker 1:And so your thought is, initially, that might be perfectly accurate way to react to information. Yes, but is it right to say that what you're describing is a kind of momentum?
Speaker 2:Right initially, but because you get this momentum and because and I think the biggest behavioral mistake that I see in markets are people they take the current environment and they extrapolate it way too far forward and we can talk about that later too. But I think what that ultimately leads to are things just go too far, and the mistake is not the initial move. The mistake is they just they take it too far.
Speaker 1:And does that happen in reverse? So is it the case that the market reacts to some information, it's initially logical for markets to price the information in that way. Markets then keep drifting. There's some momentum to what happens. Is it equally a mistake when the market realizes its error and reverts? So does it go too far to the other side? Or is it wrong to think of that as a mistake and instead think of that as the sort of correction fulcrum? There's some place over which the market then suddenly thinks it's time to correct?
Speaker 2:I like the idea of the correction fulcrum.
Speaker 1:I think I mean, if you think I made that up, by the way, I don't know if that's a phrase, but Boom.
Speaker 2:That's perfect. I mean, I might have to borrow that now. I'll give you full credit for it, of course. But yeah, I think that's right. I think what you've got happening is that I mean it's like a pendulum, right, I mean, and it swings too far in both directions. And if you ask me, and if you ask me, like sorry, I'm going, I'm going to be like, what's the literary style where you just go off on Stream of consciousness?
Speaker 2:Well, so stream of consciousness style here, that pendulum can move in both directions. But markets also Benoit Mandelbrot's book on the fractal nature of markets. I think that occurs over both long periods of times and shorter periods of time, and if you want to arbitrage that, you can arbitrage it over longer cycles but even shorter cycles, and I think there are ways to do both. But the way that we look at it is we're looking over longer cycles and when it gets too far in one direction, but it makes sense to take the other side with the idea that that pendulum will swing back.
Speaker 2:And so the mistake to me it's like and you see this everywhere right, was it a mistake for markets to, I'm trying to think, the tech bubble of 2000. Were markets wrong that a lot of these companies were going to redefine the economy? Were they wrong that in aggregate, technology companies were going to do really well over a long period of time? Of course they were not wrong, they just took it too far right. They valued them in 2000 way ahead of where they needed to be, both good companies and the petscoms of the world. The market wasn't wrong, it was just it overdid it.
Speaker 1:I mean, there's a lot of disagreement in the world about whether economics and finance is like physics or whether economics and finance is like biology. Let's go with the first one for a minute, because you're talking about pendulums. So there's the nature of an object in motion to continue in motion until it's met by an equal and opposite force, and there's the force of gravity, and so that's how we know where the pendulum will get to before it reverses. What's gravity in markets?
Speaker 2:before it reverses what's gravity in markets.
Speaker 1:What is gravity in markets? So what's?
Speaker 2:the force that pulls the market away from its extreme. So I think it's got to be valuations right. I think that I mean this is a classic Ben Graham. Ultimately, how did he say it? I think he said that intrinsic value is like if you imagine a barrel like a wine barrel, sealed, and it's just hollow inside no wine, just air and you push it under a river that's frozen over, it's going to bounce up against that ice and eventually it will break through. And his view was that intrinsic value is like that barrel. Eventually, intrinsic value breaks through. Don't ask me why, I have no idea, but it does. And so I think the way that we operate, our strategy is we're looking at valuation spreads we can talk more about that later but when valuation spreads just get too wide, it's ultimately, in our view, a matter of time before they come back.
Speaker 2:Now, the risk to this is you don't know how wide they're going to get. Some cycles they get wider than others is you don't know how wide they're going to get Some cycles they get wider than others. And it can be very difficult because you might view this is pretty damn wide, that gravity should be kicking in, and it can take a while to kick in and in the meantime, while you're waiting for it to kick in, you're basically getting kicked in the teeth. Your investors are bad at you. You know there's all these things you have to deal with, which is why it can be a difficult strategy, but it's also why it works.
Speaker 1:It's possible that we can shift now back to biology, because maybe the problem with understanding markets in the way that we're talking about them is precisely because there isn't a fixed force called gravity. There isn't the barrel full of air that Ben Graham wants us to believe is bouncing up against the ice, but instead it's humans exercising judgment and bringing to it whatever baggage they have with that judgment.
Speaker 2:This is the beauty contest analogy right.
Speaker 1:This is the beauty contest analogy, and so is it possible that the amount of force in the opposite direction might be weak for a really long time.
Speaker 2:Yeah, I think that's right.
Speaker 1:And if so, how do we forecast these preference shifts Like? On the one hand, it's fairly easy to take the example you gave, where there's some economic news and the market reacts to that news. The question I'm asking is how do we forecast that the preference shift's longevity is going to be as long or as short as it might be?
Speaker 2:And that is probably the number one question that we focus on in our strategy. I can tell you this Objectively when you look at the data, these shifts, when they get really wide, they don't last. I've never seen periods where they last more than five years. Now people will immediately be like wait, value is underperformed for 10 years or more or more. But that's actually not true. In the last 10 years we've had periods where value has done very well. It depends on how you look at it. But when we see these valuation spreads that we look at get out of whack to the point where we think it's interesting. It's tough to find a period much I mean typically three to five years. It sorts its way out. So there's objectively just history. Now that could change. But ultimately I think what needs to happen is markets need to and it gets back to the behavioral shift.
Speaker 2:If liquidity is drying up, it's a terrible environment for behavioral stuff because you typically are not going to get a mean reversion until liquidity, the liquidity cycle, turns up, because liquidity when it's increasing risks are just lower. Right. If there's ample liquidity for refinancing out there, companies can make more mistakes, there's less risk of bankruptcy All of these things that people are running from get a little bit better when liquidity is ample. And so what can cause mean reversion? Well, liquidity cycle could turn up and maybe these companies that are going through problems maybe they start actually doing things to, maybe they start investing better, doing better things, so you could have a liquidity shift.
Speaker 2:Maybe management behavior, since their stock price has gotten so beaten up, they realize crap, our stock price is in the tank. We need to start doing get a little bit of. You know, it's almost like you know if you have a really dry bundle of sticks, it doesn't take much of a spark to get the fire started. I think when you have very cheap valuations, when you have liquidity cycles that are really ugly and dried up, ultimately liquidity comes back it always does and ultimately companies that you know their stock price has been absolutely destroyed. Management has to make changes, and so a combination of a better macro environment and micro changes can create just a little bit of incremental capital moves back in those direction and the stocks double right and then all of a sudden it's like wow, these out-of-favor names are really moving and then more capital kind of starts to come in and the cycle reverts. So it's something like that.
Speaker 1:And I want to be fair to the idea, because I think a lot of what you're saying to maybe an uninitiated listener might sound a whole lot like just plain old-fashioned mean reversion, which is to say there's a certain dispersion of observations around the mean and so you don't ever expect any one observation to be the mean, and if it gets right. But I think you're saying something more complex than that. I think you're saying something more interesting. I think you're saying that humans are humans. This is not about the number of observations, most recently, that are higher than the mean, and that's just going to statistically require that it come down. I think you're saying emotionally, psychologically, investors in markets are attaching themselves to ideas or attaching themselves to views that tend to keep that price going until they no longer attach themselves to those views.
Speaker 2:I had a friend of mine that used to work for Miller Coors and he would always say there are only two types of beer in the world. There are lagers and there are ales. Everything is classified under one of those. I think there are only two types of investment strategies in the world there's mean reversion and there's trend following of some sort. Every investment strategy, I don't care what it is, I can put it under one of those buckets. So I think behavioral definitely is a mean reversion type of strategy. So I would say that's our logger. It's a logger. That doesn't mean all loggers are created equal, but what drives? That is exactly what I think you just said. People do attach themselves to ideas. I can give you an example of how I think the average investor works.
Speaker 2:Right now, what do they see happening when they observe the world, when they observe markets, they see a group of companies that are absolutely crushing it, and those companies are Microsoft, nvidia, apple, amazon, up until recently, tesla although Tesla had a good day the other day the Mag 7. And why are these companies doing so? Well, well, the narrative there is powerful, as Waltham Odron talks about I think he had a book called Narrative in Numbers about how narratives affect valuation. It's a great book. You should read it if you haven't. But that narrative is a powerful driver of how humans react to that stock price.
Speaker 2:So there's two things happening, right. There's fundamentally what's happening with the company. So NVIDIA is benefiting from this massive amount of investment into artificial intelligence, into testing AI systems, which require the chips that they make, and there's undoubtedly that dynamic is occurring in their businesses, firing on all cylinders. That's like phase one. Then there's the reaction to that which is the stock price going up a lot. Right, this is what is the theory of reflexivity. I believe is what Soros calls this. So there's the underlying fundamental dynamic. Then there's the reaction to the dynamic which is causing the stock price to go up. Then there's the reaction to the price going up. That then feeds the media cycle. Everybody's talking about it. Now investors see this. They're like, wow, that's killing it. The fundamental story makes sense. I can understand it. Of course AI is going to change the world makes sense. I can understand it. Of course AI is going to change the world. We're not wrong about that. It is.
Speaker 2:If you haven't read the Coming Wave, read that book. It's great. Ai is probably the most important issue of the day and this company is benefiting on all cylinders, firing on all cylinders, benefiting from it. The stock price is doing well. The media is talking about it. I'm now in the mind of an investor. I'm like I want to be invested there. I've invested there it's doing. I'm doing my investments up 80% year to date, or whatever. Ed, you see me and you're like shit, jeff, that's great. And now you, you pile in and it just goes and we have attached ourself to the idea and we are along for the ride, okay, and take you and me and then, just, you know, iterate that to every investor, right, and ultimately the thing gets valued to the point where the fundamental driver and the actual valuation becomes so far extended or disconnected you might say, or disconnected, yeah.
Speaker 2:That it ultimately mean reverts. Now take that little NVIDIA thing that I just did and just flip it on its head and imagine some company that's going through problems. Right, the same thing happens to the downside. So we attach ourselves to these ideas, we respond to the response, and we respond to the response of the response, of the response to the point where it just gets carried away too far. And when that happens now, not to say that every company is going to mean revert, that's gone down a lot, or every company that's gone up a lot is going to fall.
Speaker 2:But and this is why I say, you have to do this in a diversified way, because in aggregate, if you have, like our portfolio is almost 200 companies in aggregate when those cycles get too far gone, that mean reversion does occur. Now you have to have faith, right, this is how they make this religious. You have to have faith that it will ultimately occur. And at the bottom parts of cycles, lots of times it feels like inflation is never going to end. The neutral rate of interest is forever higher, which, by the way, I don't believe.
Speaker 1:Well, it's the classic this time is different, this time is different.
Speaker 2:The minute you hear, this time is different. We're almost at that full, we're almost at that point. I'll give you an example of this. And this is a macro. And, by the way, as we were talking about before the podcast, I believe macro is more and more important than ever. The new economic narrative du jour is that the neutral rate of interest, which the rate that balances supply and demand in the economy, has risen and rates, structurally, are going to be higher going forward. And, by the way, this is another reason why you don't want to invest in small caps, because they might have capital structures that are designed for a low-rate world and we're going to be in this higher-rate world and these companies are effed. Okay, somebody needs to explain to me why, for the last I don't know 40 years, neutral rate of interest has done nothing but come down. Okay, it's come down. Why? Well, all kinds of reasons. You know. The supply and demand of loanable funds has shifted in a way that's caused that neutral rate to come down. Right, we've productivity is not what it once was Aging population. You know, capital investment is less capital intensive than it used to be, All these things, if you read Ben Bernanke's book on monetary policy in the 20th century.
Speaker 2:One of the overarching themes that comes out of that book and it's a great read, he's a great writer, I think is that the problem the Fed has dealt with is the problem of a continually falling neutral rate of interest. Because the problem is, if the neutral rate gets too low, it becomes very difficult to stimulate in a downturn. And this was the Fed's number one worry, like what can we do? And this is why they've had to augment their policy with Ford Guidance, with QE and all these things. All of a sudden, this problem that's been brewing for 40 years gone.
Speaker 1:It strains credulity? Yes, unless of course. It's one of your fulcrum moments and it just took 40 years in the making to get us there.
Speaker 2:OK, but I've yet to hear a good description of why that is. What makes more sense to me is that we overstimulated during COVID. We had all kind of shifts in buying patterns of people that caused all these prices to spike in the goods market, and now they're fed through into services and every time you get a bad inflation print it's like oh my God, inflation is here to stay. It's the 1970s higher neutral rate. But, like this last inflation print, you look at what's in it, what was driving it. It's two things. It's how goods, by the way, are in deflation.
Speaker 1:But not housing and not auto insurance.
Speaker 2:That's exactly right. It's housing and auto insurance, both of which are very lagging backward-looking. If you look at the Zillow data, housing is not nearly rising as quickly as what would be implied. Those are old numbers. In auto insurance, there's also a huge lag there. That's finally responding to the spike in car prices. So those two numbers if you actually open up the PCE deflator report and actually look at it which nobody does like I spent on Friday morning Well, a lot of people do, some people do but.
Speaker 2:I hope so. I feel like I hear these people come on TV and talk about how, oh my God, inflation is just won't quit and I'm like did you open up the report and actually look at what's driving it? Did you? Because I feel like if they would, they would be you know more sanguine, a little bit more sanguine.
Speaker 2:And why I'm saying all this is what's happening is it's the number one bias that causes all of this. We extrapolate the current environment too far forward and I think to me we're not in some structural inflation. You know 1970s type of environment. We're working our way through it and I think you're going to get a lot of mean reversion in small caps when this becomes apparent. But markets have to be beat upside the head sometimes to see it and so sorry, I went on a tangent there, but I think that is.
Speaker 2:Those types of dynamics are what drive these cycles are what drive these cycles.
Speaker 1:In a way, though it's not really a tangent, because it's a great illustration of the question I was asking, which is, you know, is it possible, since we're not dealing with the laws of physics, but we're dealing with human psychology but is it possible that some overreaction can be so extended, even though there are no rational reasons to support it?
Speaker 1:And it sounds like your view is maybe, like maybe, maybe, it's not clear. What it does raise for me, though, is a really concrete question, which is you said the phrase, you said patient and you said painful about investing in a strategy where you're trying to, yeah, the P's and Q's of investing in a strategy where what you're trying to do is trade on these. Let's call them preference shifts or behavioral mistakes, whichever we want, without getting too technical, because I think a lot of our listeners aren't terribly technical, but they've heard our core podcasts and they understand what's involved in shorting inequity, and they understand what it is to be long in equity. They've learned about call options and put options and other levered ways of executing bullish or bearish trades in equities, but, sort of in a very basic way, walk someone through how an investment strategy that wants to capitalize on these preference shifts or behavioral mistakes, executes and by giving the illustration, point out to us. So see, this is where it can get really painful.
Speaker 2:Yeah, okay, so I'm a big believer, and I said this earlier, that if you want to execute this type of strategy, it's not a stock picking strategy and, by the way, I think there are great stock picking strategies that need to incorporate a more quantitative approach, but this is not one of them. I think this is a quantitative strategy that needs to be diversified across a lot of positions, and the reason is, if you think about what essentially so our portfolio is, I think just under 200 names. Right now, it's about like 195.
Speaker 1:And that's combined long and short.
Speaker 2:So that is long. That's an equal weight. Long, so about 200 names long, trevor Burrus. Long, yeah, equal weight across the portfolio. Now on shorting when we short, we short to hedge, not for alpha, and when we do short, typically we're shorting indices to try to reduce exposure, trevor Burrus, just to take away the systematic risk to some.
Speaker 2:Trevor Burrus yeah, exactly Anybody shorting individual stocks that's a whole other podcast. That's a dangerous game and is the GameStop saga can prove. But I think you can short specific indices to reduce exposure. So when you're long say 200 games what is the bet you're making?
Speaker 2:Well, it's like the horse track analogy right, the best horse to bet on at the track is not the favored horse the favored the odds are against you. The odds are against you, right, it's the horse that is a five-to-one dog, that you're getting ten-to-one on your money, so it's like a classic kind of poker situation. Now, that's a good bet. You should take it. The problem is that horse still probably is going to lose, so you don't want to put a lot of money in that one bet. But what you want to do is find a ton of bets like that and then you spread it out and then, in aggregate, you're going to do really well, right, and so that's when you implement a strategy like this.
Speaker 1:But that's sorry, just to break for a second, but that suggests and maybe you do believe this, but that suggests that, as investors are expressing their preferences, they're not just expressing preferences about the systematic risks broadly or the macro risks broadly. It sounds like that implies that they're also expressing preferences about individual companies.
Speaker 2:I think so. Yeah, I think they are, because, I mean, take for instance the a very popular way to invest in the last years and I've been to investor. I know other people that run funds and I go to their events and I've heard several fund managers say something like we want to be invested in companies that do not rely on external financing. They don't have an external financing need, they're self-funding because this is not an environment you want to have to rely on external financing. Completely logical perspective. The problem is that everybody knows that and everybody thinks that, and here again it goes too far. And so, for instance, say, like biotechs, we've had a lot of biotechs that we've been a big basket of them, we've been invested in. These companies rely on external capital.
Speaker 2:Now, individual companies might have, you know, a little bit of incremental good news or bad news, you know, based on their pipeline or something, and investors will respond to those updates. But because those companies are so out of favor, the responses are exaggerated. So a company comes out and says we've had to, I don't know, they've had some delay or something. Or maybe they've one of their drugs got some incrementally bad news. Stock's down 40%. Well, would it normally be down 40% Well, probably not 40% in an environment where the market was more forgiving to companies that required external capital. But in a market like this, there is no forgiving.
Speaker 1:And so the move.
Speaker 2:Because people's preferences are so anchored to the idea that the need for external capital is a bad signal, right, it's a negative signal, and if you just think about the supply and demand for that in particular stock, on that day there's no incremental buyers and only incremental sellers. And so how far does the price have to drop to actually bring somebody like me in? Well, the number is 40% maybe. And so in that, yeah, and so in that environment, they're responding both to micro developments and a macro. It's like a combination.
Speaker 2:But ultimately, let's take biotechs as an example. Do you want to try to stock pick there? No, I mean, unless you're really armed with very sophisticated scientific knowledge on these drugs, the bet that we're making is that, in aggregate, a lot of these companies have just gotten way killed and that ultimately liquidity will turn back up, and when it does, you're going to get mean reversion in the space. And so, to answer your question real quick, you want to be broadly diversified, and there are a lot of ways to get diversified. It might be as simple as just owning the Russell right now. I mean that might be an easy way to play it on the IWM or own, you know, if you wanted to get exposure to biotech. There's baskets, but you want a basket type of approach. You do not want to try to stock pick. I don't think.
Speaker 1:So in a strategy where you're trying to capitalize on these preference shifts, one takeaway I'm hearing is you just want to be long the companies where it's clear that their stock price has gotten beaten up. That sounds like a classic value strategy.
Speaker 2:So how is it different, or isn't it maybe? I mean, so it depends on how you execute it. At its core it's not really different. I mean, I think you hit the nail on the head how do we do it? So the way that we do it that I think is different is we're not looking at and to kind of go into a little bit, I assume that you've talked a little bit about Fama French and their approach.
Speaker 2:So you know, a traditional value approach if I'm just living in a Fama French world would be own the bottom deciles, the cheapest deciles of stocks. That's traditional value, right? Just, I want to own all the cheap stuff. The way that we would look at it is actually we don't want to own just the cheap stuff, we look for what we call behavioral deviations. So we basically take a Fama view of the world in the sense that we rank companies and create portfolios based on valuation metrics.
Speaker 2:But we create those portfolios every day and we track every company in our universe. So 4,000 some odd companies historically which portfol book-to-market that is the aggregate market belief of where that company should be ranked in terms of its valuation multiple, based on the market's beliefs at that moment in time about that company's growth and reinvestment opportunities can earn above their cost of capital. All the things that you need are going to trade at the higher end of that range and companies with crappier prospects can trade at the lower end. Historically, value has been like well, let's do mean reversion, but we're just going to own all the cheap stuff because it gets too far gone and that still works.
Speaker 1:Sometimes Sometimes. And then you get the value trap sometimes still works, sometimes Sometimes. And then you get the value trap, sometimes right, but it sounds like what you're describing is really focused on the behavior. So you're looking at a company and you're asking the question where does that company usually sit in a price to book ratio Right? Where is its typical home? And now you're looking at those that vary from that, because that's your signal that what you've got is a shift in preferences about either that company or the or that equity risk at large.
Speaker 2:I should take you on the road with me. You just nailed it, that's it, yeah. So, for instance, you might have a company that was in portfolio. So we do 20 portfolios. 20 is the most expensive decile. One is the, as I say, the dog shit, the cheap stuff. You might have a company that's been in 20 its entire life. That the market wakes up a day. Well, that was a trigger for us. I think. If memory serves, it went from like portfolio 20 to maybe 17 or 18. So it was still an expensive, quote-unquote company. Value guys wouldn't touch it. But what attracted us to it was the pace at which it fell. To us it signaled correlated errors and all these things. So we look at deviations. So we're not looking at an absolute level of value. We're looking for where a company has lived and where it is now and the pace at which that decline happened. So it's different, but it's still mean reversion.
Speaker 1:And ergo why patience and pain were the two words that I latched onto, because if what we're talking about is the moment, it's not physics, it's biology.
Speaker 1:So the moment at which that preference shift is going to undo itself, where the market will figure out it's overreacted, can take a while.
Speaker 1:In a strategy like this, the risk is not, as might be the case in some strategies, that the costs of shorting are too significant and therefore you're betting against, because I mean one could it sounds like one could decide to execute a strategy like this by being short the stocks where the preferences have bid the price up too high. It's in a tercile or a decile. That's way above where it normally sits. But the risk, the most obvious risk to me there is if these behavioral shifts take a while, that's not just what an inconvenience. That's very expensive to be borrowing that stock and having that short open for such a long period. What you're describing is a different way of identifying and capitalizing on the same idea, except you're just looking at the ones that have dropped in terms of where they normally sit and then you're long that stock. When you think about this, I mean I just think it's super compelling. What does this mean for passive investing and, from your point of view, what does passive investing mean for the way markets behave, like this or don't?
Speaker 2:So for passive, I don't know him that well but I've met him a few times.
Speaker 2:He's a great guy.
Speaker 2:A guy named Mike Green has done a ton of work on this and so he has a lot of YouTube videos you can go watch. But the general idea is that the shift to passive investing has created I think he describes it as the perfect mechanism for destroying active management for destroying active management, and I'm probably not going to give this whole theory justice, but the basic idea is, let's say we're both active managers and we're investing in a mean reversion type of strategy, like I've described. And let's say, as inevitably they can go through periods where they underperform, your investors get impatient and they decide to you know, to fire you and they're going to take all their money out and you're going to have to basically redeem by selling all the cheap stuff that you own, which is going to further drive down the price of the cheap stuff. Okay, and then you're going to take that money and give it back to the investors. The investors are then going to put it into a passive fund, like you know, spy. The SPY is going to Well it's market cap weighted.
Speaker 1:It's market cap weighted, so it's buying mostly the expensive stuff.
Speaker 2:The expensive stuff, right, and so a passive fund. They're not discretionary in the sense that they look at valuations. You give a passive fund a dollar, they buy a dollar worth of stock. You take a dollar out, they sell a dollar. They're completely price inelastic right, and there's a paper called the inelastic market hypothesis that's really interesting to look at. But basically that passive fund then buys the S&P, which is market cap. Weighted Market cap doesn't or volume rather doesn't scale with market cap, so there's a disproportionate effect on the largest companies and those companies do extraordinarily well.
Speaker 2:And now you're out of a job. And now wait, now that's hit me now. Now my investors are like because I probably own a lot of the similar stuff that you had to sell, so my performance goes down when you sell. And now my investors are like Jeff, what the hell? Look how the S&P is crushing you. And then they fire me. And then now I have to sell and so that further drives the price down. And now there's some other value manager that's now suffering, and then my money gets shoved in the S&P and it just exacerbates things.
Speaker 2:So what does that do? Ultimately, it does two things. It makes life as an active manager difficult. It requires more peace, more patience and, all you know, more pain, but ultimately it probably creates bigger dislocations. So, if anything back to what you were saying earlier about how long does the cycle last, I think something like passive can exacerbate the length of the cycle. But, like anything in life, if you, if you do one thing, you know there's no free lunch. If you exacerbate the length of the cycle and the amount of dislocation, ultimately the snapback when it occurs should be, in theory, larger, but I think it's. My experience is that the cycles have lengthened and you just look foolish for a long time, I mean when the S&P is going up the way that the S&P is going up, driven by these companies, and you own a basket of behavioral deviations that are underperforming. Yeah, life is difficult. As an active manager, it might be the case that the best way to run the strategy is with private capital that doesn't have those pressures.
Speaker 1:But we read headlines all the time where five years ago CalPERS is out of private equity because of what they perceive as subpar returns and now CalPERS has increased its allocation to private equity because of what they perceive as subpar returns and now CalPERS has increased its allocation to private equity. So even private capital investors aren't necessarily so patient. But I think I'm hearing you, I think I get it that you're pointing at passive and you're saying maybe not the sole contributor, but an important part of what might be driving the momentum of the psychology of the market, because it creates a positive reinforcement for what you believe is happening.
Speaker 2:Fuel to that cycle.
Speaker 1:You're believing right. That's the way you described it earlier, which I think is nice to think about it this way. There's some news. It's positive news. The market reacts positively to stocks. Then people react to the new increase in the price of stocks. That reaction engenders more increase in the price of stocks, and then investors then shift away from other investments into passive vehicles that invest in that, and they're buying more yet of the same, and so I think I see what you mean about how passive is. You characterize it as the enemy of active investing, but on the other hand, it just may simply be a contributor to something that an active investor like you can try to capitalize on, and so without it, maybe you have a harder time extracting that.
Speaker 2:And somebody might rightfully ask why would I want to fight that? Why not just ride that wave?
Speaker 1:Somebody might rightfully ask why would I want to fight that? Why not just ride that wave? You perceived the very next question, which is we hear in the bond market learned a long time ago, 50 years ago don't fight the Fed. This sounds like an equity market version of don't fight psychology. Why is that wrong?
Speaker 2:So it gets back to the two types of beers, lagers and ales, right. So you're now in that second bucket, which is the momentum. And you know we, our fund, right now, is angled towards mean reversion. I do think, however I mean, like any strategy, our strategy is always evolving.
Speaker 2:I think there's an argument to be made to and a lot of factor investors blend factors. We want some momentum, they want some value. That's one way to do it. But I think and I'm going to probably get myself in trouble, but I don't care I think factor timing is not a crazy idea. I think, if you have the view that this cycle is a lot longer in the tooth than people think, you could tilt more in favor of a momentum type of strategy and less in favor of a mean reversion. So maybe you're 70 percent, some type of momentum. I'm not going to fight the passive shift, but I also realize that we're ripe for mean reversion. So I want to have 30 in a mean reverting strategy. That will benefit and you could play it that way. But that gets into factor timing, which I know is a very controversial topic. But I think there's a lot of evidence that factor timing, on value in general, can add a lot.
Speaker 1:Listen. This has been a terrific discussion. I really appreciate your time, jeff. I'm thinking about ending each of these episodes with a moment of just let's call it your pearl of wisdom. So just a quick and short. It can be worldly wisdom, market wisdom, personal Zen wisdom, but just a little something for listeners and we'll sign off.
Speaker 2:Man. Oh, and listeners should know I was not prepped with this question, so I have to go off the cuff. I would. I'm trying to think, since it's investing, I'll give an investing one that my dad, who was my first teacher when it comes to investing, was my father when it comes to investing, was my father, and he gave me two things that have always stuck with me. One is, when it comes to investing decisions this isn't always true, but it's a good rule of thumb that if making the investment really feels good, probably not a great investment. If it hurts like hell, it probably is going to be a better investment. I always like that. It's not always true, but it's a decent rule of thumb.
Speaker 2:The other thing he said that always that I think is really healthy is that, especially in a mean reversion strategy where they can be volatile, he's like never forget when you look at your portfolio in the morning and you're like you're having, you're on a tear, you've been crushing it and numbers just keep going up and up and up and up and up.
Speaker 2:You're never as wealthy as you think you are because you have to pay taxes and ultimately stocks can turn down. He's like on the flip side of that when you're going through a bad period and it seems like every day is down and down and like, oh my God, I can't win. He's like you're never as poor as you feel either, because in those environments typically all your stocks are massively undervalued. And oh, by the way, any losses you do realize you get a tax shield on that will offset the ultimate gains you're going to make when they do mean revert. So you're never as rich as you think and you're never as poor as you think, and just never forget that. So those are two pearls of wisdom at investing that I learned from my dad that I think are really good.
Speaker 1:Jeff Henriksen, thanks a million, great chatting with you.
Speaker 2:Awesome. Thanks, Ed, for having me and take care.
Speaker 1:You've been listening to Not Another Investment Podcast hosted by me, edward Finlay. You can find research links and charts at notanotherinvestmentpodcastcom. And don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
.jpeg)