A value-investing maven explains why bargain-hunting has lagged.
Our guest on the podcast this week is Charles de Vaulx. De Vaulx is chief investment officer and portfolio manager at International Value Advisers, where he is also a partner. With his colleague Chuck de Lardemelle, de Vaulx manages the IVA International and IVA Worldwide strategies. Before joining IVA in 2008, de Vaulx had been the portfolio manager of First Eagle Global, First Eagle Overseas, First Eagle U.S. Value, and First Eagle Variable. For his accomplishments, Morningstar has recognized de Vaulx several times in the past, awarding him and his comanager our International-Stock Manager of the Year Award in 2001 and nominating them for the same award in 2006. De Vaulx began his career at Societe Generale Bank as a credit analyst in 1985. He graduated from the Ecole Superieure de Commerce de Rouen and holds the French equivalent of a master's degree in finance.
Background
IVA Worldwide IVWIX
IVA International IVIOX
References
Modern monetary theory (MMT) definition
Herfindahl-Hirschman Index (HHI) definition
Creative destruction definition
A History of Interest Rates, by Sidney Homer and Richard Sylla; 2007
"The Irresistible Charm of the Family Factor," by Credit Suisse, Sept. 27, 2017
"The Superinvestors of Graham-and -Doddsville," by Warren Buffett, Columbia Business School, May 17, 1984
Berkshire Hathaway 2013 shareholder letter, Page 20
Superforecasting: The Art and Science of Prediction, by Philip E. Tetlock and Dan Gardner, 2016
Jeff Ptak: Welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.
Ptak: Our guest this week is Charles de Vaulx. Charles is chief investment officer and portfolio manager at International Value Advisers, where he is also a partner. With his colleague Chuck de Lardemelle, Charles manages the IVA International and IVA Worldwide strategies. Before forming IVA in 2008, Charles was portfolio manager of the First Eagle Global, Overseas, U.S. Value, and Variable strategies. For his accomplishments, we've recognized Charles and his comanager Chuck several times in the past, first in awarding them our International-Stock Manager of the Year Award in 2001 and also in nominating them for the same award in 2006. Charles began his career at Societe Generale Bank as a credit analyst in 1985. He graduated from the Ecole Superieure Commerce de Rouen and holds the French equivalent of a master's degree in finance.
Charles, welcome to The Long View.
Charles de Vaulx: Good morning.
Ptak: So, maybe we'll start sort of with a broader topic, which is, value investing. Value investing has been slumping versus growth for quite some time. You are a value investor and therefore have very valuable perspectives on why that might be and why wasn't this foreseen. So, what can you share with us about why value investing has had the struggles that it's had over a multiyear period now?
de Vaulx: OK. Well, you're starting with a heck of a question. And I'm sorry to report that I have an answer for you, but it's somewhat of a comprehensive answer, somewhat of a long answer. So, please bear with me.
Ptak: Sure.
de Vaulx: Yeah, I think, there have been for many years now several trends that have made value investing very difficult. But I believe that most of those trends hopefully will be temporary and not secular.
Let me start with ultra-low interest rates, which probably, in my opinion, have been the most powerful trend that has hurt value investing. Most market participants would agree that interest rates are central to the security-pricing exercise. Sovereign bond yields are typically used as a proxy for the risk-free rate to which an equity-risk premium is added to obtain a discount rate to use in any discounted cash flow analysis model. Interest rates can affect the valuation exercise in several ways. They affect the discount rates. They also have an impact on corporate free cash flows available to equity shoulders via interest expense. But interest rate changes may also have been driven by changes to economic growth outlook and/or changing inflation, deflation outlooks, which themselves will affect the growth rates of corporate cash flows. And finally, interest rates and thus discount rates do affect the valuation multiple applied at the end of the forecast period in a DCF analysis.
So, my point today is to highlight that changes in interest rates affects value stocks much less than growth stocks. Value stocks have lower growth rates than their growth counterparts. As a result, a larger portion of their business value is derived from cash flows in the near future. And conversely, a lot of the value of growth stocks is derived from cash flows in the distant future. So, another way of expressing this is to say that growth stocks have a much longer duration, a word used in bond land, than value stocks and vice versa.
In fact, I've asked the other day, our trader, one of our traders, Ken Caccavale, to run some numbers on treasury bonds. And so, I said, if the yield to maturity on a 10-year treasury bond were to rise from 1.7% to 4.7%--a 3% move--that Treasury bond price would drop by 24%. If the yield on a 30-year treasury bond yielding, say 2.2% were to rise by 3% to 5.2%, that bond would see its price drop by 45%, almost twice as much as the 10-year Treasury bond. Again, it's amazing what a difference in duration can mean for valuations.
So, basically, over the past eight years, the intrinsic values of value stocks have compounded a lot less than the intrinsic values of growth stocks. And on top of that, real absolute-return value investors have been hampered by the lack of stocks offering enough of a discount, enough of a margin of safety, hence, oftentimes large cash positions. If you look at the performance of our funds, for instance, both the Worldwide and International funds, our underperformance over the past five to seven years has been overwhelmingly due to the dilution from the cash--cash as a residual of our inability to find enough truly cheap stocks as opposed to our stock-picking itself, or our value approach. At least that has been obvious until the last 18 months.
Likewise, it has been said that Berkshire Hathaway has lagged the S&P 500 for the past 10 years. But if you stripped out the cash, which typically has been around 20% of the intrinsic value of Berkshire Hathaway, the rest did outperform the S&P 500. And I would argue that it was done by Warren Buffett with a lot less risk based on the types of businesses owned, either fully owned or through marketable equity securities.
So, not only do ultralow interest rates raise interesting questions regarding relative valuation of value versus growth stocks, but also these rates have been totally distorted by central banks, and have also probably resulted in misallocation of capital, especially in some of the value-friendly industries. I don't think the Shale Revolution and what happened to Permian Basin would have reached the same extremes and caused the value destruction it has if rates had not been held so artificially low.
Ptak: Can I jump in with one question?
de Vaulx: Sure.
Ptak: So, I think it's a really interesting thesis, and we're going to get to these other points, which I think are buybacks, business cycle, reversion of the mean and so forth, but this has been a prolonged cycling down of interest rates over many, many years …
de Vaulx: Since the early '80s, correct, 1982.
Ptak: Exactly. And so, during a period of that time value stocks were outperforming growth stocks. I think that certainly there was a period where they were slumping versus growth and there was a sharp dislocation, when the tech bubble burst and we saw value trounce growth. So, if duration is the factor that--you've said it is--how do we reconcile that with the record of value as rates have cycled down …
de Vaulx: Well, I think the answer lies in the other points which we will cover later …
Ptak: OK.
de Vaulx: … which has to do, just to give you a prelude, the fact that when rates went down in the past, it was typically accompanied by a very high economic growth, which was good for many of the value stocks, many of which are cyclical stocks.
Ptak: OK.
de Vaulx: But more importantly, and we'll touch upon it later, the growth stocks in the past did not remain growth stocks for a long time. Quality businesses did not remain quality for a long time. So, the fade rate--the rate at which growth fades away or quality fades away--has collapsed since then. And so, these are some of the points I will touch upon later.
Ptak: That's helpful. I interrupted you. I think that you were making another point.
de Vaulx: So, the other point has to do with the huge buybacks—stock buybacks—especially in the U.S. Now, these buybacks may have helped grow the intrinsic value per share of many value stocks. But it has made it very difficult for these value stocks to truly ever become cheap enough to offer the required margin of safety and thus be bought. Hence our large cash position, or Berkshire Hathaway's, for that matter. For many years now, U.S. investors have been selling equities and buying bonds. I guess they were also buying piece of businesses by investing more and more in private equity, at least the institutional investors. But the selling of equities was more than offset, or maybe equal, by the huge buybacks to the tune of $4 billion, $5 billion, $6 billion, $700 billion worth of shares a year. So, a combination of record-high corporate profits, modest capital expenditures, and ultralow interest rates have allowed many U.S. companies--small, midsize, and large--to do massive buybacks.
Not only did companies use the repatriation of overseas cash reserves in 2018, but they were also willing to incur additional indebtedness to do stock buybacks that appear to be accredited on an earnings-per-share basis. And conversely, outside the U.S., you would have noticed that buybacks did rise from very low levels, especially in Japan or South Korea, but still remain modest. So, as a result, many foreign stocks have lagged the U.S. market enormously over the past eight years, and many more stocks were allowed by the market and, undisturbed by buybacks, to trade at decent discounts at times, enabling the value investors to buy them. And so, as a result, interestingly, value investing has been working much better outside the U.S. than in the U.S., at least, relative to the benchmark.
And if you look at the respective performance of our Worldwide Fund, which is the global fund, compared to the pure International Fund, it will be striking for you to see how much better our stock-picking has been outside the U.S. and I think because of many reasons, including the lack of buybacks outside the U.S.
Ptak: So, just to reinforce your point, it sounds like one of the things that you're saying is that because companies are buying back as aggressively as they are, the discount to estimated intrinsic value is not widening to a point where it can be exploited in order to capture the premium that value investors are accustomed to capturing. Is that a fair characterization?
de Vaulx: Yes. Thank you for making it as clear as that for our listeners.
The third headwind for value investing, especially in the U.S., has been the lack of any business cycle, especially since 2009. I was very intrigued to read back in--was it a year ago, in November 2018--a black book by Bernstein, the renowned sell-side research firm, that book was titled An Economic History of Now. The first essay was what penicillin, heart disease, and cancer tell us about the business cycle and recession risk. That piece drew a parallel between the introduction of penicillin, the resulting huge decline in death risk, while the risk of dying from cancer or heart diseases at a later age, mind you, has gone up. And the fact that the expectancy of the U.S. business cycle has gone up a lot as well. Bernstein noted that compared to the 19th century--well, during the 19th century, they found out that the 50% of the time was spent in a recession, only 26% of the time during the 20th century, and only 8% of the time so far in the 21st century. The average length of economic expansion used to be 25 months in the 19th century, 44 months in the 20th century, and now 101 months so far in the 21st century. The average depth of GDP decline was 3.7% in the 19th century, 4.3% in the 20th, but only 2.1% so far in the 21st century. And conversely, average real growth was 4.1% in the 19th, down to 3.6% in 20th, and only 2.8% so far in the 21st century. Again, a lot more muted.
So, again, I think listeners have to appreciate the more volatility there is, not only the stock market, but in the economy, the more it is easier for value investors to practice their trade. You need periods where markets overshoot followed by markets that undershoot, you need that volatility. And the fact that we've had… When I think about our funds, for instance, if you think about the bread and butter of what we do, even though eclectic, a lot of what we do has to do with buying quality businesses that are cyclical, and it's precisely the cyclicality of those that enable us to buy them during a downturn and sell them later.
Think about a quality business as defined by Warren Buffett, a business which over a full economic cycle generates an above-average return on capital employed, above-average level of free cash flow. Think about a temporary staffing: Manpower, Adecco; think about advertising, billboard advertising; think about freight forwarding, Expeditors International, the equivalent in Switzerland, Kuehne + Nagel; think about Costco. We've been able to own Costco several times in the past, each time whenever there was a proper economic downturn in the U.S., the growth guys would panic, the earnings would probably, not necessarily go down but the growth rates would decelerate, the growth guys abandon ship and we were able to step in and buy it. Costco is cyclical. Tiffany is cyclical. Richemont, which we own, they are luxury watches and jewelry, is cyclical. And so, when there's no business cycle, it's a little bit like your consumer staples, they never get cheap enough.
So, I think that's an important point that Bernstein makes. And of course, I refuse to believe that that state of affair which Bernstein describes is sustainable. I think we've had this illusion of no business cycle, because we've had to put more and more and more and more debt in the system. Now, not so much at the household level in the U.S., but a lot more at the corporate level, a lot more at the government level. That has been made possible because interest rates keep getting lower, so that debt can be serviced. But in my mind, that is not sustainable. I think in the fullness of time, we will have again proper economic ups and downs in the U.S. helping enormously value investors.
Benz: I have a question on that front. So, how would that play out? Do you envision … So, we'd go through some sort of economic slump and value investing might sort of perform better on a relative basis and then in the recovery really …?
de Vaulx: That's one scenario. Or as you know, there's more and more talk politically about MMT and fiscal stimulus, I mean, for lack of a better word. If that takes place, and again, we will have important political elections here, then instead of a downturn the economy may bounce back, which finally would trigger maybe some inflationary pressures and higher interest rates. That would be a wonderful scenario for value stocks in absolute terms. They might be able to be up in the financials, but many others, and the growth stocks because of much higher interest rates would take it on the chin. So, again, I think value could do better either on a relative basis if there's a downturn or in absolute terms if the economy does recover in the U.S.
Ptak: So, as another way to think about that, you know, there's a certain payoff that a value investor can capture investing in cyclicals because they have to ride this cycle or court the uncertainty that goes with trying to understand where they are in the cycle and to the extent that that's muted, there may be isn't the same sort of risk premium that's offered to them just because they're not having to endure to the same extent that they would. And then, on the other side of that ledger with growth equities, the fact that you have better look through the cycle to these more distant cash flows, do you feel that's one of the reasons why growth investors and growth stocks have had a better go of it, just because with the cycle more muted, you can see through to those cash flows in the distance to an extent that you wouldn't be able to otherwise?
de Vaulx: Correct. Again, thank you for explaining it as well as that. And of course, by the way, if we do have a real downturn, it would be interesting to see what were the growth stocks today that were masquerading as growth stocks, meaning that there are probably many growth stocks today that are more cyclical than we think there are. Or even think about Alphabet, which we still own, or Facebook. I mean, the more market share they have of advertising, the closer they are to reaching the plateau and then advertising is cyclical. So, it will be interesting to see in a downturn also what are the real growth stocks and what were just pretend growth stocks.
And if I may continue, because I think that's very important, to talk about the third headwind, which has been--I mean, going back 15 years now--the lack of reversion to the mean for many quality and growth stocks. In the past, one of the reasons value investing has worked well had to do with the fact that growth investing, as well as investing in quality names, is actually quite difficult. I remember a piece by the quant team at Bernstein, again the sell-side firm, 15 years ago, showing that growth stocks lose their growth-stock status quite quickly. After three years, half the growth stocks had lost their growth-stock status. After five years, two thirds had lost that status and after 10 years, 90%. These numbers were based on 50 or 60 years of history in the U.S. Now, I don't know what these specific numbers would be over the past 10 years, but I suspect that the fade rate has slowed down nicely for growth stocks, meaning that they can retain their growth-stock status longer than before. And we've seen it with Facebook and many others.
Now, Bernstein has recently given numbers regarding the evolution of fade rates for quality companies, as distinct from growth companies. And the change there is striking as well. According to them, "In the early 90s, the probability of remaining in the highest quartile of profitability measured by return on equity, five years later was 30%." Now that probability has jumped to 50%. Now, instead of looking at ROE, you look at margins, same thing. The probability of a top-decile margin company remaining at least in the top-two deciles after five years used to be 50% in the mid-90s. Over the past five years that has been 90%. And to add insult to injury, a large part of that shift has been due to the scalability and network benefits of intangible assets, which some value investors can struggle with. I of course enjoyed immensely hearing Bill Nygren argue, rightly so, that book value, tangible book value, is and should be less and less and less of a relevant metric.
And I also believe that that increased profitability and ability to sustain that profitability has been driven by a huge wave of consolidation that the antitrust authorities have allowed so far to happen in many industries, especially in the U.S. You all know that a higher Herfindahl-Hirschman Index, HHI, a commonly accepted measure of market concentration, typically results in more oligopolistic and higher profitability ratios. And yet, I worry that change… I wish that change might be on horizon so that the fade rate could increase again for quality companies and growth companies when you see politically both in the U.S. and in EU some of the political establishment is starting to reflect and think about the risk of too much concentrations for the big tech firms, Facebook, Google, Apple, Amazon, but also in many other sectors.
And then, to continue on that theme of lack of a revision to the mean, same thing on the other side. While quality names and growth names became better and for longer, we witnessed the opposite trend in so many other sectors, many of which are typically associated with value investing. Of course, I'm referring to the massive technological disruptions that have affected sectors such as retail, oil and gas, media, advertising, automobile, the financial sector, as well as parts of the food and beverage industry, or other consumer staples. Think about the craft beer and Dollar Shave Club, et cetera. Many of the names in these industries looked cheap many years ago but were value traps as the new competitive forces were unleashed.
So, what I discussed, I think, goes a long way to explain why value has faced such headwinds. But I also believe that many of these headwinds are temporary.
Ptak: That's helpful. So, maybe focusing on those last two points that you were making, reversion of the mean and disruption, I suppose a skeptic could argue that those maybe aren't new things necessarily that markets being characterized by sort of creative destruction, call it, right, that that's always rippling through and that value is always going to face headwinds of that sort and some. So, I guess, what I'm asking is, what is unique about this more recent period that we've gone through that's created, I guess, unique challenges for value in each of those two respects that you mentioned.
de Vaulx: Well, you know, Schumpeter's creative destruction has been with us for a long time, but I and for my sense, I've read too much economic and financial history, I wish I were ignorant and would blissfully enjoy the bull market. I cannot remember any time where the disruptions were so massive. And then, when it comes to interest rates, I mean, you know of the book by Richard Sylla on the history of interest rates going back 4,000 or 5,000 years. This is totally unprecedented to have interest rates that are as low, in fact negative, in absolute terms, in so many countries. So, I believe that some of the trends today are unique in how extreme they are. And also, politically, frankly, I--and maybe that's the European in me. By the way, I did become a U.S. citizen a year ago, very proud to be. But I marvel at how patient the electorate has been. I mean, we live in democracies. Now, there's been rumblings, the French, the Yellow Jacket, Brexit, some populist movements here and there, some countries tempted by socialism, maybe in South America. But I am impressed, surprised that there hasn't been more of a rebellion.
Ptak: So, being the global investors that you are you have the unique vantage of being able to look across a number of different markets, some of which I would imagine have gone through a more fully formed business cycle, boom and bust, right? Have you found that value has worked better in some of those markets in your portfolio or more broadly speaking?
de Vaulx: Yes, I mean, in economies that are most cyclical, like Germany, France, Japan. Now, France, interestingly, some of the companies are global companies. Sodexo is a global company; Pernod Ricard is a global company. So, these companies do not cater specifically just to the French market. But our experience has been that stock-picking and value investing has worked far better in these countries. And also, what we've observed--but now going back 30 years, that's not a new phenomenon--is that companies where there is a huge insider ownership, now oftentimes it's maybe a family that controls the company. And you've heard that before. I mean, the companies with big insider ownership, surprise, surprise, tend to do far better in the long run than other companies. And this was not conventional wisdom on Wall Street 30 years ago. The idea where you know, where you should avoid family controlled businesses that are not listed. Sooner or later a dumb son or daughter will get to run the business and they don't care about maximizing profits and this and that. And yet, I think it's Credit Suisse many years ago decided to do some research and they have devised an index called the Credit Suisse Family Index where they track around the world, in the U.S. and outside the world, family-owned businesses and it's striking to see how much better those have done. I mean, Berkshire Hathaway is insider-owned, if you will. Think about some of the leading French companies, they are big companies, but family controlled. L'Oréal has been a remarkable company; Nestlé, in a way which is part of the L'Oréal galaxy; Pernod Ricard has been very successful, I mean, became a giant next to Diageo.
We've been dabbling in Japan for over 20 years now, having sold our last Japanese security at my old firm back in 1988, it is remarkable to see how much family-owned businesses do far better than the others. I mean, it's day and night. One company we had had a good experience with was--well, the name has changed, but it used to be Temp Holdings--it was a temporary staffing company founded by a woman in the 1970s. Now, that is a cyclical business, but it's capital light, it's a service and over the years, that company has done exceedingly well. Now, sometimes in places like Korea, you have to be careful. Some of the chaebols, which are family-controlled, sometimes will do things that are not in the benefit of minority interest. So, you can't assume that every family-owned business will do well. You still have to be careful and monitor corporate governance and capital allocation, but it's been good for us.
Oftentimes people will look at a portfolio over the years and will marvel at the fact that we have typically a lot more in France than in Germany. Say, "Charles, we're confused. We thought you didn't like the French." So, I [say], "Yeah, they annoy me at times.” But the fact is that there are phenomenal companies in France: L'Oréal, Sodexo, we've mentioned, Thales, and many others. Robertet, which was a flavors and fragrance company that we owned for a long time and many others. But then I have to remind people that there are very few German-listed companies. What they call--I don't know if it's der deutsche mittelstand--the industrial fabric of Germany is comprised of 100% family-owned businesses that never, never have had to raise equity capital. They would never list them. And some of them are industrial giants. Bosch, you know, the spark plugs, I mean, it's a giant. Bertelsmann, the media company, is 100% private. So, we do like those family businesses.
Now, one of the quirks in South Korea is, if I understand this correctly, is that there are some rules regarding estate taxes whereby the tax authorities look at the share price, maybe along with other things, to assess the estate taxes. And so, when in the family, as might be the case today with Hyundai or Samsung, when the old man might be about to die, there is this perverse incentive of trying to make sure the share price is as low as possible. So, we have to live with those kinds of quirks.
Benz: So, I'd like to talk about active versus passive investing. There's a lot of research out there, including some that we do here at Morningstar, suggesting that it's getting tougher for active managers to add value, even before fees come into play. So, reflecting on your own experience over the years, do you find this to be true? Is it getting tougher for active managers? And talk about the extent to which investor flows into passively managed products have created opportunities for you or have resulted in headwinds.
de Vaulx: Well, thank God, Christine, that the passive wave has happened. For 20, 30, 40 years, I have, before that, whom I've worked with for a long time, was saddened by the fact that there was so many, you know, closet indexes and index huggers and they were charging a fee but yet never truly wanted to deviate that much from the benchmark. And we conversely said that we were--on one hand, we were different because we were diversified. Many people wrongly tend to equate active management with the running of concentrated portfolios. But our way of doing it, the Jean-Marie Eveillard way, was to have diversified portfolios, 100, 150, 200, 250 names, but yet names that had nothing to do with the benchmark. And even more than that, we were willing to make what we called negative bets. Now, being along only to make a negative bet, means basically owning little or nothing of what may have become the biggest part of the benchmark.
In the late 80s, we had no Japanese security. In '89, late '89 with the Japanese bubble burst, Japan was 40%, 45% of the MSCI world. I think it was 55% of the MSCI world ex-U.S. 10 years later, the tech bubble, TMT stocks, both here in Germany, in France to some extent, Japan, tech stocks were 30%, 35% of most benchmarks. We owned none of them. In '06-'07 around the world, the biggest part of the benchmarks were these financials. And I think they did not do too well in '08-'09. So, yes, good riddance to all these fake active guys. The active guys that deserve to survive are those that are truly active, again either in a concentrated way or our way, and active funds that have shown a willingness to be attentive to their size, make sure they don't get too big and as a result cannot deliver the goods, cannot perform. We have had our funds closed for a long time. We reopened a year ago because after having suffered some redemptions. And then, I think some of the institutional investors, I think, are right to understand that some areas of the marketplace are probably a lot more efficient than others. I don't know, say, large cap U.S. stocks. So, just maybe if you want your beta, buy an ETF or a passive fund, and for less-efficient areas, which I believe international investing, still international markets, especially small- and mid-cap markets, maybe high yield, maybe distressed--I think those are areas where some active managers should be able to keep adding value.
Now, of course, people who start putting more and more of their money in passive funds should understand that there's no downside protection. And so, they have to make sure that characteristic is in line, one, with the investment objectives and also the temperament. I'm obviously a huge fan of Warren Buffett, the owner of Berkshire Hathaway. But I am puzzled by the fact that he is urging… Now he, by the way, who used to make the seminal speech at Columbia University showcasing, proving to the world why value investing was a superior strategy. Warren Buffett doesn't seem to bother defending value investing anymore. But he's urging everybody to buy a low-cost index fund, S&P 500, and he's advised that his wife should have 90% of her money in that upon his death.
Now, Warren Buffett always has said that he does not equate volatility and risk. That's fine. But that's him. I don't think Warren Buffett truly acknowledges the fact that most individuals, most are not able to cope with the volatility that indices entail. It was not too long ago--what was it, from September '07 to March of '09--the S&P dropped 47%, 48%. I don't know many people who, if they had 90% of their wealth invested in that, would have had the fortitude to stay the road. The only reason why Jean-Marie Eveillard invented our way of investing, the SoGen way, which became the First Eagle way and hopefully now the IVA way is, our awareness that most clients do not tolerate volatility, downside volatility, well. And so, we've created vehicles that put a lot of emphasis on limiting that downside volatility. But the other part of the equation is also our belief, and that's a mathematical belief, that one of the best ways to compound wealth over time is to minimize drawdowns. So, I don't know if I've answered your question, but …
Benz: Yeah. No, you have. What about the thought that somehow indexing is mutating markets or causing markets to behave differently?
de Vaulx: I want to believe that it probably exacerbates at the margin some trends, if people pull out of an active fund so that that active fund has to sell some maybe, you know, decent stocks, and then the money then goes into an index fund that has to by definition buy more Google and Apple and so forth. So, I think, at the margin, it exacerbates thing. But I really want to believe that … I think closet indexing, I think, had the same perverse impact. Even during the tech bubble, many active guys felt that many of these tech stocks were outrageously priced, but they still wanted to own some because they felt they had to. I think the true reason why value has not done well, and why growth stocks--it has to do with what I discussed earlier, these very low interest rates, the buybacks, the M&A, the lack of reversion to the mean. I think these are the true ultimate drivers. The rest is noise.
Now, I think, yeah, there's a lot of questions about the structure of the markets or is the market as liquid as it used to be and what happens when ETFs have to face redemptions? So, I think these are real worries and questions, but not the ultimate drivers.
Ptak: So, you alluded to sort of your risk-minded approach, your absolute-return-focused approach to running money. I don't know that all of our listeners will be familiar with your particular ethos. And so, margin of safety, not limiting yourself, going anywhere, holding cash. I mean, I've probably ticked off a few of sort of the telltale attributes of your approach. But maybe you can give sort of as a succinct answer of how it is you try to protect the downside for your investors to an extent that perhaps a closet indexer wouldn't.
de Vaulx: So, we are unusual in the long-only space because we do try, especially for the Worldwide, which is not a specialized fund the way the International fund is, to deliver positive absolute returns. In most active funds out there, long only seem to be in the business of trying to beat the benchmark. Why, by the way, do we have that goal? Because we believe that most individuals' goals, in fact, are aligned with our goals. There's something very asymmetrical when it comes to money. You only need to be rich once. So, that creates an asymmetrical proposition. And then, if you're not rich, you cannot afford to lose that you have. So, no matter what, if you're rich or not rich, when it comes to money, you have to… basically, it means that you cannot take much risk. Or another way of putting it is, you should be willing to own risky assets only when the risk/reward is tilted in your favor. And that's what value investing properly executed does for you. Value investing is the belief that markets at time can be inefficient and you have to buy individual securities that trade below their real value, their intrinsic value. And if you do that successfully, then your downside is all the more reduced and the upside, all the greater, the upside being reversion to the mean from price to value. And then, if it's a good business, the value will have compounded over time.
I think it was just two, three years ago I read a book by--it was Ed Thorp, the guy who basically… He was a mathematical genius, the quant guy and MIT, was able to find the way to beat the casinos at blackjack. And the essence of his mathematical method was, he had to make sure that statistically the odds were in his favor. So, again, I think that most people cannot afford to lose, and should only take risk when they are paid for the risk. So, that's the background.
Now, how do we do it? By using a value-investing principle, you know, it's asymmetrical as all the goals I just talked about. It's by being willing to be eclectic in the sense of trying to go where the values are. Sometimes the best bargains are might be in small stocks, sometimes in large stocks and that changes. Many industries are global. We have always been willing to look beyond U.S. borders. I was chatting earlier, and I was reminding you, Christine, that 30 years ago, value investing was a strictly a U.S. affair, practiced by U.S. guys, Ben Graham and company, on U.S. stocks only. It was, I think, Warren Buffett said he kept a few stock certificates of Cuban companies in his drawer to remind him of the dangers of what can happen beyond U.S. borders.
Then we are willing to buy high-yield bonds, corporate or sovereign, because when a bond yields 8%, 9%, 10%, 11%, they can be equities in disguise to use an expression coined by Dan Fuss from Loomis Sayles. Now, I think Dan Fuss said it best. He said, at times they are equities in disguise. That's a good thing. At other times, they're just mere bad credits. So, you'd have to do your homework. And by the way, one of the tenets of value investing has to be cheap but safe, safe and cheap, Marty Whitman. And of course, companies discover the joys of leverage, you know, especially in the 2000s, not only financial companies but companies levered themselves up because its cost of capital—so much easier to lower your cost of capital if you substitute equity with debt. And so, many companies were so levered that they were maybe cheap but not safe. And the value guys were in '05, '06, '07, the value guys were like, wait a minute, how can I do safe and cheap if nothing is safe anymore? GM was not safe. AIG was not safe. And many others; Vivendi was not safe. And so, well, be creative. Just go out, go as a value guy, be creative. Go one notch higher in the capital structure. Maybe the debt is not all bank debt, maybe it's bonds. So, that's one way.
Another way is gold. And hopefully, we'll talk a little more about gold. Gold is a … Warren Buffett is correct. It's not investment. It's a bizarre thing. It doesn't yield any income. It doesn't generate free cash flow. But gold was used as money and gold—it has this intriguing attribute whereby in the past, more often than not gold will be inversely correlated to stocks and bonds. So, if you're a long-only guy like us who tries to deliver positive returns, to have something like gold that can zig when the rest of the portfolio zags, that's pretty cool.
And finally, cash. We are willing to hold cash. If you ask a real value investor, what's your buy discipline? Well, hopefully, I'm lucky, I find stocks, enough stocks that trade at a big discount to the intrinsic value, the margin, so you buy them. If you are lucky, the price meets value. If it's a good business, intrinsic value will have compound over time. What's your sell discipline? Well, price meets value, I'm out of there. Well, if it's a compounder, you may still want to retain some and so forth. And so, price meets value, you sell. When you sell, you raise cash. And sometimes when you do that, you have not been able to find new attractive opportunities. So, you just sit on that cash while looking for new bargains. So, in that sense, cash has to be viewed as a residual of this buy-and-sell discipline that I explained, as opposed to cash being a tactical tool or some sort of call on the market.
As I explained earlier, one reason why for many years we've had 30%, 35%, 40% cash is that because of these low rates and these buybacks and the lack of economic volatility in the U.S., stocks never--they were sometimes within 1%, 2%, 3%, 4% of the price, we will have bought them, but they were not quite cheap enough. Then in terms of the style of value investing, value is a big tent. You had Ben Graham, who favored tangible book and the net nets. And then, of course, you had Warren Buffett, who during the 70s saw the light because of the stagflation at the time, because of the influence of his friend, Charlie Munger, and realized that sometimes – there was something to be said to pay up for better businesses. And then, of course, later you had Bill Miller, the new, new value school and now maybe you know, along the same vein of Bill Nygren with Alphabet and Netflix.
So, our value approach has been more on the qualitative side, I would say. Cyclical quality, the cyclicality is what enables us to sometimes buy them and sell them. And then, we tried--for every company not only do we try to compute an estimate of what the intrinsic value of the company is, and for that we, by the way, do not do our own DCF, discounted cash flow analysis. We rely as much as possible on M&A transactions, mergers and acquisitions. Well, actual businesses have been bought for cash. We have a database of multiples, which sometimes are not, it's not P/E ratios. It's enterprise value to sales, to book value, to two hectares, to all sorts of metrics. We are aware that sometimes corporate acquirers overpay, especially when interest rates are low, and money is overly abundant. So, when we think buyers are overpaying, we will haircut these M&A multiples.
And another thing we do which has helped is, besides computing a core intrinsic value estimate, our analysts compute a worst-case intrinsic-value estimate, using harsher assumptions. Under some scenarios, what happens to margins? Of course, God forbid, there's a little bit of leverage, you know, how much does the leverage multiply things and so forth. So, I think that's the way we try to achieve those objectives. There's no free lunch, though. One of the drawbacks of our approach is that markets tend to go up a lot slower than they go down, especially in an environment like today where the business cycle seems to have been repealed, at least in the U.S. And so, our investors have to basically see us lag and lag and lag for many years while the markets go up. And then, hopefully, when markets correct, we can be resilient enough to do well enough and then retroactively over the whole period will have done well.
Benz: So, let me ask that question. In hindsight, do you regret that you didn't buy bonds in lieu of holding cash?"
de Vaulx: Well, again, we don't mind bonds when they yield 8% plus, which we view as equity-type return. I showed you the math earlier also in reverse, apropos the duration of value stocks versus growth stocks. Had we known that interest rates would drop from 5% to -0.1% and so forth, yeah, we should have bought bonds. But that's not what we do. And we never try to forecast--you know, what's the saying--only God knows the future and he ain't telling us. And even though I understand why we have all these deflationary forces going on, either due to industry disruptions or some of the monetary policies that are followed, I still think that if I were a wealthy client, I want to believe that the ultimate nightmare is inflation as opposed to deflation or disinflation. Now, don't get me wrong. Deflation is not something that's amusing. I mean, the American psyche has been marked by the Depression. Deflation is not easy. Companies default. People always associate gold with inflation. They forget that gold can do very well during deflationary times because gold is not an IOU. Forty percent of banks, I believe, default in the 30s.
So, if you're wealthy and you fear deflation, if you are exceedingly careful about counterparty risk, I think you can do OK. Conversely, if inflation or hyperinflation comes, I think it's a lot harder to maintain your wealth in real terms with inflation and hyperinflation. So, what I'm trying to say here is, maybe I'm going back to Pascal—Pascal was this French theologian, mathematician. And his insight, which Peter Bernstein has harped about is that, when it comes to investing, it's not only about assessing the odds, what are the odds of deflation and lower interest rates versus the odds of inflation or hyperinflation? Equally important, maybe more, are the consequences. So, the way Pascal put it is, what are the odds that God exists. He doesn't exist. Maybe the odds are 50-50. He doesn't exist, and you behave fine. But if you misbehave and God exists, I mean, the consequences are terrifying.
So, even though I don't know going forward or I did not know in the past if interest rates would go up or down, I believe that the consequences of interest rates going up and inflation going up are far more terrifying. And I cannot also help believe that we live in democracies, we've been used to fiat currencies for a long time. Even when we had the gold standard, the politicians found it not too convenient. So, they changed it for something a little looser, the Gold Exchange Standard and then we finally got rid of the attachment to gold. And I do worry that the next step will be inflation. I think Ray Dalio from Bridgewater speculated recently in a long piece about the possibility that we may enter, that there may be a paradigm shift, that policymakers now will have to try different things, maybe fiscal stimulus and an MMT and, therefore, that could be monetized. So, I have no regrets.
Ptak: And so, you mentioned inflation and perhaps there's the risk that we've slept on inflation and it could rear up on us. Is it expressing itself in any manifest ways in a portfolio right now? Obviously, you mentioned gold. And so, that's one way. But maybe any other way in which you've sort of incorporated that into your thinking and portfolio construction?
de Vaulx: Well, but you know, like, I made the point gold, in fact, can do well with deflationary times. In fact, gold has done quite well since '08 in fact, 2008. But if you think about the types of businesses we own, I argued earlier, we have a bias toward quality. Quality oftentimes means that companies have some pricing power, which by the way, also is good during deflationary times.
Ptak: Yeah.
de Vaulx: So, the fact that we own companies with good balance sheets, with pricing power, cash, would not hurt during inflation, will not hurt the way bonds would. So, I think, yeah, inflation coming back would help us a lot.
Ptak: I'm curious, just with changes in markets, it's quite a bit easier for portfolio managers even at scale to transact. I mean, one of the arguments that you might have made for cash is the optionality it gives you, right? You don't have to move the portfolio around if you have that there. It doesn't seem like that presents the same sort of challenges that it used to. I'm not suggesting that when you're managing billions of dollars, as your firm does, that it's simple to transact in a position that you have to work that trade. But by the same token, do you see an argument that maybe value investors—committed, thoughtful value investors--should own less cash because they can do what they need to do to take advantage of opportunities as they need to just given the ease of transacting?
de Vaulx: Jeff, I don't think it has anything to do with the ease of transacting. It's go back to, you know, what's the buy discipline of value investor? I mean, it has to have it at a discount. What's the sell discipline?
Ptak: So, for you this is just a residual?
de Vaulx: It's a residual. And think about the legendary value investors. First of all, most of them did not bother shorting stocks, a different ballgame, although it's tempting. If our expertise, value guys', is to appraise businesses, why not buy the cheap ones and short the expensive ones, right? But it's a different game and most great value guys never had to resort to shorting, sometimes just in a limited way for arbitrage and so forth. But all of them believed in the right to hold cash. I think Ben Graham somewhere wrote that, even if you as a money manager are able to find, say, 20 stocks that are factually cheap, like in the sense that God whispers in your ears and your analysis is correct, the margin of safety is there. If at that very moment, the market as a whole, Mr. Market as a whole, is expensive, he argued, you may want to keep 20%, 25% in cash or short-term bonds, because you're deluding yourself to believe that these stocks that are factually cheap will not at least temporarily go down.
And then, Jeff, when I look back at our performance--now, yes, have we lagged over the past five, six years, but our performance going back 30 years, part of it was Jean-Marie Eveillard and then later without him--I believe we've done very well, even though we used cash quite generously. And so, why change something that has worked? And then, oftentimes I'll have clients that remind me, but you know, you guys are good stock-pickers. I'll say, well, then, you know, buy us on leverage. If you are sort of a risk parity, buy us with some leverage. So, I keep doing my little (quizzy) and I sleep well at night. And then, you spice it up if you want the equity-only portion. So, there's ways to do that.
Benz: So, one of the things that you strive to do is to smooth out the bumps. And I think it seems like a goal of that would be you can kind of keep people in their seats, that they're not fleeing in times of market turbulence. So, do you attempt to measure that in any way to see, well, have we indeed kept people on board in difficult times? Do you look at dollar-weighted returns or something like that?
de Vaulx: No, I don't, but I know that our clients are very patient with us. When we launched IVA, was at 11 years ago, I would say two thirds of the money that went our way were clients from the past. These guys and women, they know the drill. I mean, they've seen as lag in the late 90s. So, they know what to expect. Now, don't get me wrong. I mean, over the past few years, international investing has been out of favor. So, oftentimes clients will go to the buyers and say, you know, why don't we have more U.S., and I hear about passive. So, I mean, we have had redemptions. But I would say that most clients are happy to see us keep doing what we're supposed to do.
Five years ago, in a conference call, I wanted to showcase that our style of value investing, which is not a low-price-to-book type thing, was in fact working. It's been working less over the past 18 months, by the way. And so, for the first time, in a conference call, I gave out numbers of the performance of the equity-only buckets of our funds going back one year, three years, inception, and the numbers were very impressive. And of course, I knew what would happen. Then some of my clients afterward say, well, can we have the real deal, can we have the fully invested version? And whenever I see clients—and I do see many clients--each time, I will ask them: guys, what do you want? Why did you buy us? Do you want the absolute returns? Or do you want the stock-picking? If enough of you want the stock-picking, it's easy. I will create the fully invested version. And typically, it's 80-20. 80% tell us keep doing what you're doing. That's how we have positioned you. And 20% argue that they want something more fully invested. A few of our institutional separate accounts have asked to be a little more fully invested, by the way.
Ptak: Maybe to widen out and talk about process and decision-making. I think this was somewhat tongue in cheek, but I think you were asked recently for your forecast on global oil demand. I think you passed to your partner Chuck de Lardemelle probably quite wisely at that. I know it was probably tongue in cheek. But I was curious what your take is on research that's been done on forecasting. Philip Tetlock's work comes to mind in whether you've incorporated some of those findings into the approach that you take in conducting research at IVA.
de Vaulx: So, remind me here, that's research on oil demand? What are we talking about?
Ptak: No. So, it's sort of best practices in forecasting and how one would come up with a forecast and whether any of that research that's been done suffuses the work that you do.
de Vaulx: I apologize. I don't know what you're talking about. I don't know these studies.
Ptak: But it sounds like you have a certain intuition around forecasting and know one’s limits. So, maybe how do you apply that in practice?
de Vaulx: So, again, the way I'll answer you is by saying that in the value-investing community, it was taboo 20, 30 years ago, to think about the macroeconomic conditions. Only God knows the future. He ain't telling us. That sort of thing. But yet, Jean-Marie and I, we were aware that around the world, starting in the 70s, 80s, 90s, there was a growing, what’s the word, financialization, of the economy. There was a growing use of debt. Now, either at the corporate level, at the household level, at the government level, and being students of the Austrian economists, Hayek and von Mises, we knew that sometimes during the debt-buildup phase, there could be excesses, and the debt buildup could result in a temporary correction, a financial crisis, if you will. And so, even though we've never done forecasting for the macro, we've always paid attention to what was happening to debt. When we saw explosive growth of debt in Japan in the 80s, besides the goofy valuation, that was a warning sign that the party would end. Big credit boom in Latin America from '92 to late '94.
Now, during the boom, the economy is on steroids, companies are doing money, some stocks may look deceptively cheap, but it's not sustainable. We saw once that took place, the Tequila crisis, the Asians misbehaved. The Asians were supposed to be the good guys where they went bananas in Korea, Indonesia, Thailand, South Korea from '95 to '98. That did not end well--Asian crisis. And then, from '03, '04 to late '07, big credit boom in the U.S., the subprime in Western Europe, in Eastern Europe. Eastern Europe, they spice it up. They allowed people to buy homes in Czech Republic or Hungary, borrowing in euros or Swiss francs. And over the past 10 years, we've seen a ginormous credit bubble in China. And so, to us, that is the next shoe to drop. So, again, I'm not answering your question. But seeing excessive developments in credit land is something that I think helps us maybe forecast or worry about what can go wrong.
Ptak: And it seems like one of the other things that you'll look at is relationships. Your foreign currency-hedging approach comes to mind, right? I think that I've heard you reference the fact that you'll make some decisions about whether to partially hedge your currency based on how it behaves in certain macroeconomic regimes. Is that right?
de Vaulx: Yes, like right now, still the yen is used for the carry trade. And of course, the currency hedging is complicated because you have to also understand what kind of companies you own in a geography. If in Switzerland, you own say, Nestlé, well, Nestlé is not already a Swiss company. So, they generate a stream of incomes in all sorts of currencies. If in Japan, you were to own hypothetically mostly the export-oriented companies that benefit from a weaker yen, you may not need to hedge. You would double hedge because these companies have a natural built-in hedge. So, we also pay attention to that.
But I think one interesting benefit, by the way, of being exposed to different markets … I talked about us dabbling in the high-yield market sometimes--not many high yields these days—is that sometimes, sometimes, the one market sniffs something ahead of the other markets and normally (might be different this time) the bond guys--supposed to be nervous Nellies whereas the equity guys like to fantasize about the upside--and so sometimes, when you see the nervous Nellies started to worry, while the equity guys are still fantasizing, that can be interesting.
I'm sorry to report them. I would love markets to go down. But I'm sorry to report that the Financial Conditions Index is still very loosey goosey. I mean, have we seen spreads widen lately in high yield and energy? Yes. But it's still very limited and not enough to signal that things are about to really turn nasty. But it's fun to have the ability to see what some markets are seeing that the other guys are not.
Ptak: Well, I think on that note, we'll close this conversation, Charles. Thank you so much for this great conversation, the insights that you shared with us and for appearing on The Long View. We greatly appreciate it.
de Vaulx: I enjoyed it, Jeff. Thank you so much, Christine.
Benz: Thank you, Charles.
Ptak: Thanks again.
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Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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