The WisdomTree CIO on ‘do-nothing’ strategies, the market outlook, what constitutes a risk factor, and more.
Our guest this week is Jeremy Schwartz. Jeremy is global chief investment officer for WisdomTree Investments. In that role, Jeremy leads the firm’s investment team and is responsible for constructing its equity indexes, quantitative active strategies, and model portfolios. Jeremy joined WisdomTree in May 2005 and previously held several posts at the firm, including serving as its global head of research. Prior to joining WisdomTree, Jeremy served as a research assistant for Professor Jeremy Siegel and is credited as Siegel’s co-author of the sixth edition of the book, Stocks for the Long Run. Jeremy received his bachelor’s degree from the Wharton School and is a CFA charterholder.
Background
Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies, Sixth Edition, by Jeremy Siegel, with Jeremy Schwartz
The Future for Investors: Why the Tried and True Triumphs Over the Bold and the New, by Jeremy Siegel
Do-Nothing Strategies
“What Beat the S&P 500 Over the Past Three Decades? Doing Nothing,” by Jeffrey Ptak, Morningstar.com, April 17, 2023.
Creative Destruction: Why Companies That Are Built to Last Underperform the Market—and How to Successfully Transform Them, by Richard Foster and Sarah Kaplan
“Wise Words in Warren’s Recent Letter,” by Jeremy Schwartz, wisdomtree.com, March 8, 2023.
“Long-Term Returns on the Original S&P 500 Companies,” by Jeremy Siegel and Jeremy Schwartz, jstor.org, 2006.
Market Outlook
“The Most Important Charts for 2023,” by Jeremy Schwartz and Brian Manby, caia.org, May 8, 2023.
Risk and Return
“A Surprise Influence in S&P 500 Earnings? The Dollar,” by Jeremy Schwartz, wisdomtree.com, May 31, 2023.
Fama and French Three Factor Model Definition: Formula and Interpretation, by Adam Hayes, www.investopedia.com, May 31, 2022.
“A Deep Dive Into Growth & Momentum,” by Jeremy Schwartz, wisdomtree.com, July 12, 2021.
“A Surprising Rebalance Season for S&P Style Indexes,” by Jeremy Schwartz, wisdomtree.com, Jan. 5, 2023.
WisdomTree Index Performance Attribution
Inflation and Dividends
“A New Regime for Commodities: An Update,” by Jeremy Schwartz, wisdomtree.com, May 31, 2022.
“To Reveal Value, Start With Dividends,” Focus Points video series with Jeremy Schwartz, wisdomtree.com, Jan. 11, 2023.
“Quality Dividend Growth Performance Viewed Through Venn by Two Sigma,” by Jeremy Schwartz and Christopher Carrano, wisdomtree.com, May 15, 2023.
Foreign Stocks
“Lowering Your China Risk,” by Jeremy Schwartz and Matt Wagner, wisdomtree.com, May 19, 2023.
“Values Strong Run in Emerging Markets,” by Aneeka Gupta and Jeremy Schwartz, wisdomtree.com, May 5, 2023.
“Don’t Layer Currency Risk on Top of Equity Exposure,” by Jeremy Schwartz and Christopher Gannatti, wisdomtree.com, 2019.
ESG
“Revisiting the WisdomTree ESG Model Portfolios,” by Scott Welch, wisdomtree.com, Oct. 14, 2022.
“Aswath Damodaran: A Valuation Expert’s Take on Inflation, Stock Buybacks, ESG, and More,” The Long View podcast, Morningstar.com, May 16, 2023.
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is Jeremy Schwartz. Jeremy is global chief investment officer for WisdomTree Investments. In that role, Jeremy leads the firm’s investment team and is responsible for constructing its equity indexes, quantitative active strategies, and model portfolios. Jeremy joined WisdomTree in May 2005 and previously held several posts at the firm, including serving as its global head of research. Prior to joining WisdomTree, Jeremy served as a research assistant for Professor Jeremy Siegel and is credited as Siegel’s co-author of the sixth edition of the book, Stocks for the Long Run. Jeremy received his bachelor’s degree from the Wharton School and is a CFA charterholder.
Jeremy, welcome to The Long View.
Jeremy Schwartz: Thanks so much for having me, Jeff. It’s great to be with you and Christine.
Ptak: It’s great to have you. Thanks again for doing this. I wanted to start on a topic, which I guess we’re referring to internally as do-nothing strategies. I’ve written some articles recently examining how different types of managed investments would have performed if they were never traded; you just left them alone, let them ride. Little did I know that you’d already done research like that some years ago. So maybe you could talk about the work you did and what you found.
Schwartz: Yeah, I loved your piece, Jeff. And this comes back to when I first started working with Professor Jeremy Siegel at Wharton. I’d been with him 22 years and the very first time I met him, it was as he was exploring the tech bubble and he was doing some work around what he thought people should do. And he was looking at how long could some of the biggest companies grow as fast as the big tech companies. We were trying to do some valuation work on the tech companies at the time. And he started going back to, let’s say, the top 20 stocks from 1950 and looking at those consistently. And it led him to looking at the returns of the original stocks in the S&P 500. And he had done a lot of work on the top 20 and I was one of his research assistants. I helped him with the third edition of the book, and I started saying, can we do more than the top 20? And it became a multiyear project where we tracked the S&P 500 from 1957 and tracked all the history of those original companies through mergers and spinoffs.
And the databases weren’t so great that I could just get that with a quick query. We actually were in the library tracking a lot of these mergers and spinoffs. I think they’ve gotten better at CRSP tracking some of that. And so, we’re trying to work on doing some other updates more systematically. We were in the stacks looking for these company histories and we tracked those original companies. And at the time, there’s all these people talking about innovation and how important it was getting market returns. There’s even a book from McKinsey, Creative Destruction. You had to keep updated with all the constantly updated new firms and all the innovation that they came with all these new companies.
And what we found was, if you went back to 1957 and you held those original companies, you had 20 % energy, 20% materials, you owned all these dying companies that were declining from 20% down to just a few percent. How could you keep up with the index? But not that you just keep up with the index, you beat the index. And not by a large amount, but if you can keep up with it was impressive. We found that in nine of the 10 sectors, those original companies outperformed the actual companies. And what you’d find was that S&P won’t add any companies for a long time and then when energy was booming in the ‘80s, they added all these companies, then they went on to underperform. They didn’t add any telecom companies until the ‘90s, then they get added at the peak and then they go on to underperform. And so, that was a pretty interesting dynamic. It was central to his second book, The Future for Investors, that I helped him write, came out in 2005. And there was a lot of lessons about this sort of growth trap that people get very excited about growth, and they end up paying up for it. And that original study was the anchor to some of that work.
Benz: You highlighted a recent Warren Buffett quote in which he attributed Berkshire’s success to, “a dozen truly great decisions.” What are the things we can do as savers and investors to ensure that we’re making the fewest, most impactful decisions possible?
Schwartz: Yeah, and the studying of Buffett comes back to, again, that first work I did with Siegel for The Future for Investors, where, as we were going again to the aftermath of that tech boom, we were studying all of what Warren said as part of the solutions for how do you manage around valuations in tech. So, I’ve read basically most of what Buffett has written in all of his annual letters and keep updated on all of his comments. I do love his comments on this 20-punch card rule, where the less decisions you make, the better off you’ll be. So, you question, do you really need to be that active of a trader? Some of that comes to making fewer decisions.
One of the things Buffett talks a lot about is buying long-term dividend-growers. In his latest letter, he talked about American Express and Coca-Cola when he bought in the ‘90s, and he bought similar sizes in ‘94 and ‘95, and how much they were growing their dividends year after year. And so, one of the lessons I said was, if you’re going to make few decisions, try to think to these long-term dividend-growers—think like Buffett in that sense, companies that are returning cash to you as a shareholder are some of the real long-term winners. And that was one of my favorite quotes of the Buffett world.
Ptak: Wanted to shift and talk about your market outlook. Obviously, you play a pivotal role in setting your firm’s market outlook, risk and return expectations. Maybe you can talk about the approach you use to estimating long-term market returns, and that’s maybe a natural segue to what your current estimates hold right now for the major asset classes.
Schwartz: So much of how we think about what the market will deliver comes from valuations. So, one of the things we talk a lot about in Siegel’s Stocks for the Long Run, it’s very clear in bonds. You say, what is a bond yield? It’s a natural connection to what are the bonds going to return. There’s not been a historical huge amount of capital appreciation in bonds. You just buy bonds for their income, and the higher the price, the lower the yield, and people can use that very rashly as their expected returns on bonds.
But you could do the same thing for stocks. That’s very much how we think about the long-term returns that you had in stocks. This comes back to Siegel. He had the longest-term study on broad market returns. Some people call it Siegel’s constant for the consistency they delivered—stocks returned after inflation around 6.5% to 7%. It’s been 6.7 % for many long-term periods. And you say, was that an accident or where did that come from? Well, there is a relationship like that for stocks just like there is for bonds, which is the valuation and the earnings yield. If you flip the P/E ratio to the earnings over price or the earnings yield, we use that as a good sense of where our looking forward real, call it next five, seven years equity return is going to be. So, if you have a higher P/E ratio and you’re not quite at 20 as the P/E ratio, but it’s close to 20—18, 19—your earnings yield is now, call it, 5.5% to 6%. Why did the stocks do the 6.7% over a very long period of time? Because the average P/E ratio was 15. That was 1 divided by 15 that got you close to that 6.7%. And so, we use that P/E ratio as a real after-inflation return indicator. There’s a lot of theory that talks about why that earnings yield should translate to good estimates of that forward-looking return. And so, that’s how we start with our bonds up—looking at P/E ratios as those real return estimates.
Benz: You just cited your expectation of long-term market returns. If I’m an investor and I want to do better than that, where should I look?
Schwartz: If I go back to where is the S&P 500 priced today, it’s a little bit below 20 times earnings. So, call it a little bit above a 5% to 6% earnings yield, is one of the ways we would say where the S&P 500 is priced. Where could you do better? It’s a similar way of coming up with those solutions. We look at P/E ratios as indications of where are there better opportunities. Obviously, there’s different growth rates—more expensive stocks are going to grow faster than the cheapest stocks. That’s always the case that the higher-priced stocks do tend to grow faster than the lower-priced basket. But as a baseline, one of the places where we think you can do better is by buying … It’s one of the reasons why we like value over the long run is they tend to get underpriced too much and should have some opportunities. So, there are some baskets of U.S. stocks that have 11 to 12 P/E ratios. High-dividend stocks in particular have an average P/E ratio, and the way we construct the index is at 11 times earnings, which is a 9% earnings yield. And they’re not going to grow as fast as the S&P, and so they should have some discount. But that’s one of the widest discounts in a very long time. And so, we do like high-dividend stocks, both in the long run, but also in the short run based on those relative valuation spreads as one of the angles.
Ptak: Wanted to shift and ask you a few questions about risk and return. What’s a risk you used to think investors got paid for that you’ve come to conclude they don’t get paid for and why did the premium dissipate?
Schwartz: There’s probably a lot of academic debate over factors and risk premiums and all these types of things. I think I want to spin this question in a slightly different way, which is, what do people think they’re getting paid for a risk that they’re taking that I don’t think that they’re getting paid to take? So, this is a question that I talk to people about a lot. And I think people are taking a lot of uncompensated risk when they invest internationally and take on currency risk, which I don’t think you’re paid to take. So, if you look at a lot of the long-term data, currencies bounce around, they have generally. The dollar has declined over the last 50 years. So, you could say, hey, it did decline over the last 50 years, and they did get paid that, but there’s no reason why the dollar is going to decline forever. And so, I question people who like to go international and take that currency risk. I think it’s something that can be a coin flip. It moves plus or minus 7% on any given year. And I think there’s increasingly good reasons and increasing evidence that the S&P 500 has a weak dollar bias built into it. I actually just published a piece today that looks at the earnings of S&P 500 companies and what happens to earnings when the dollar was rising or falling. And when the dollar was rising over the last six months, the forward six-month earnings over the last 50 years was generally zero. But when the dollar was falling, the forward six-month earnings was roughly 6%. So, on an annual basis, call it 12%.
That’s a massive difference between S&P earnings growth, which is biased toward this weak dollar bias, and it’s been stronger over time. So, the last 25 years, that number goes up to like almost a 900-basis-point spread for when the dollar was rising or falling. You could see it in just this latest earnings season. You can go back six months ago, and the dollar was one of the strongest in history. And it was a very, in general, negative earnings picture this quarter—earnings were down about almost 8%, because of the 15% rise in the dollar six months ago, if you go back six months ago. Now it’s turning out to be a little bit better because the currencies have been weakening from those highs. And so, maybe you’re going to have a good earnings setup six months from now. And call it in October, you’ll probably get good earnings. But this extra risk, this weak-dollar bias to S&P makes me really question why people like to take additional double down on currency risk when they go overseas. I don’t think they’re paid to do it. And I think this is uncompensated risk. So, that’s one of the things I think people get wrong a lot.
Benz: What’s the difference between a real risk premium and noise? And maybe you can give an example of something that was previously touted as a premium, but that you correctly saw as data fitting or randomness.
Schwartz: Noise is an interesting word there. Going back to the founding of WisdomTree, we talked about the noisy market hypothesis as a contrast to the efficient-market hypothesis. And once you start talking about noise in pricing, it gives you all sorts of questions about what should you do to a portfolio. Because if you think the markets are efficient, you’ll just be in the cap-weighted market portfolio. But once you say things go away from efficient markets and you have these noisy markets, you can say, you can do better. And then the question is, how do you rebalance away from that noise and come back to some kind of fair value for those companies? So, that noise word is an interesting one.
I think in terms of things that people talk about as deserving of premiums, but may not be always premiums, I think there’s some interesting questions in the original three-factor model. The Fama-French three-factor model that said your expected returns are a function of your beta to the market, your size, and your value exposure. One of the things we’ve written on a bit, and this was in Stocks for Long Run—some of the early editions, but even just this latest edition that came out—the sixth edition last year, we talk about small caps as a factor. Are they a risk factor that deserves these excess returns? They did over the last hundred years—small caps were these strong factors. But you look through, when those returns came, it was very concentrated from ‘75 to ‘83. And if you take out those eight years, they really didn’t outperform in the U.S. And you say, are there some unique things from it? Some of it could have been, right after the Nifty 50 large-cap tech bubble, and there were some things there, obviously very high inflation. But there was some pension rules that changed that allowed pensions to allocate to small caps. And it was a massive run of ‘75 to ‘83 that drove all of the 100 years’ outperformance. You look internationally, and there’s been some evidence that it’s done well in places like emerging markets, in Japan, say the last 15 years, where large-cap growth in the U.S. dominated everything else and small-cap value really struggled. It has worked in some other regions, but I think the small-cap question is, are they deserving of an excess-return question? That’s one where we had some evidence that a lot of it was just the ‘75 to ‘83 period that we talk about for the small caps beating large caps.
Ptak: What do you think is the most arguably counterintuitive relationship in finance that’s profitable investors? And on the flip side, what’s maybe an example of something that’s very intuitive, but that routinely costs investors?
Schwartz: This is an interesting question on what’s counterintuitive. I just talked about efficient markets and so the noisy markets—I think if you believe in efficient markets and how hard it’s been for active managers to consistently beat indexes and ETFs. You look at your Morningstar data, you’ll find how strong ETFs have been in their categories for beating the vast majority of active. Yet you say, well, what’s something that has consistently shown to work? Momentum is one of those factors, I think, that has shown very good returns. You say, why should this work? It’s one of the most transparent factors that exists. And if it’s known to work, why does it continue to work? And if anything, you could say some of these momentum stocks get carried to very extreme levels. You could say some of the stuff happening in the markets now are getting carried to extreme levels.
With all this data on how strong it’s working, it’s interesting in terms of where do people get things wrong or where can it cost people? So, people start looking at momentum as this great factor. And for the last 15 years, it starts working very much alongside growth. And so, then you have some of the index providers start adding momentum to their growth indexes. In particular, S&P added the momentum factor to the growth style. And there was some really interesting rebalances that I wrote about last December when it was happening, how basically you had growth companies, a lot of the big tech companies all had that momentum. I think it led to this idea that momentum rhymed with growth. But then, you look at what happened last year, and you had all these consumer staples—utilities, energy stocks, which did very, very well during the downdraft—started showing very strong momentum. And the tech companies, which have been good growers, fell out of favor, and they were no longer growth stocks. The big tech companies, a lot of them got added to value indexes and they lowered weight. And then, you saw energy getting added to growth. They did have very strong earnings growth last year, but this year it was not expected. Their earnings are actually the biggest decliners this year. So, it’s very interesting there where you see this thing working and then the index providers add it. And it leads to some very counterintuitive allocations, particularly if you’re a growth investor. I think that’s something people need to spend a little bit more time looking at that growth value methodology there.
Benz: WisdomTree was at the forefront of the fundamental indexing movement that came to the fore a few decades ago. As you look back on it, what are the biggest lessons you’ve learned?
Schwartz: You develop a process that you think will add excess returns. We do believe in—I talked about the noisy market hypothesis being one of the foundations for trying to reweight a market-cap index away from cap weighting toward value-type weightings. Then you have one of the biggest growth booms in history. It has been a 15-year period where growth was dominating really, and last year was the first big year back for high-dividend value in a long time. So, it can be a long time from when you think something should work and deliver excess returns to how long it actually plays out. You could launch things after it had a very good stretch, and then that stretch becomes challenged.
But I think when we look at the history, I think we’re very proud of how things have performed compared to some of their peer groups. We have some of our original funds, things like our large-cap dividend strategy launched 17 years ago, 5-star in Morningstar. It’s done a very good job in all of its peer groups. We have that track record across—you’d have 17 years of data where you could see how these things have done. I think what we found is interesting how dividends have changed from those days back in ‘06. You had tech, which was the smallest dividend-paying sector, now the largest. You have things like Microsoft and Apple being some of the top dividend-payers. It’s evolved over time. I think when you look at some of the ways other value indexes are created, things like price/book have struggled in keeping up with some of those technology companies in many ways. You could go to all sorts of accounting questions on that.
But the broad dividend weighting in some ways has been a higher-quality value basket, but it’s very much classified consistently in your value boxes because it avoids some of the most growth-oriented companies that tend to not pay dividends. So, it’s a very interesting history, and we’re keeping at it going forward.
Ptak: You mentioned dividend-weighting. I wanted to ask you whether you’ve done any research in which you’ve tried to isolate how much value that earnings or dividend weighting has added to or subtracted from performance? Have you done work like that?
Schwartz: I think we’re constantly trying to give attribution. We have some attribution tools on our site that break down all sorts of style factors. There’s the standard sector factors, but we try to break it down to how much comes from overweighting the highest-yielding quintiles, how much comes from the shift to sectors and quality. So, I’d encourage people to use our index-attribution tool on all these questions for dividends, for earnings. We provide it across all these categories. Often, there’s a combination of things that work because you are shifting sectors, you are shifting toward those higher yields. So, it becomes definitional of how much is stock selection, how much is allocation.
Often it is stock selection when you look at it as a sector level because there’s obviously a sector shift and the stock-selection shift, but it’s probably added—I don’t want to speak to one specific number—but you can look by every time period, every index we have. I think it’s interestingly where it’s worked best, where the dividend factor has worked best in our 16, 17 years has been emerging-markets small caps. You don’t think of EM as like—and small caps in particular—as a place where dividends are going to work the best. But it goes back to—even when we first started writing about dividends, one thing we liked about dividends was that it’s transparent, it’s one measure that can go across countries, you don’t have to worry about different accounting standards. You even think about how did companies, when there was accounting scandals in the U.S.--this was one of the things Siegel wrote back when I first started working with him in 2002 about the Enron accounting scandals. He talked about they should make dividends tax-deductible like interest and firms would pay out all their earnings as dividends and you’d have no questions about how much could you trust the books and the accounting. But in emerging markets, they tend to pay out a huge amount of their earnings as dividends. And if you look at the 20% of the broad MSCI EM small-cap index that didn’t pay a dividend, those stocks were down 2% a year for the last 17 years. And you look at the highest-yielding quintile and those stocks are up 8% a year for the last 17 years.
And so, that’s where it’s worth absolutely the best. Again, the U.S. has been a little bit different market with tech and growth leading the way. But if anything, maybe that says, maybe it’s time to be cautious on some of those places. But in EM, it was a classic place where value, high dividends work, the nonpayers work the least best, and it was a real drag on broad market indexes.
Benz: You’ve referenced several times the research that you’ve done with Jeremy Siegel and Stocks for the Long Run. Can you talk about inflation and the relationship between stocks and inflation? Your research does point to stocks being probably the best inflation hedge that money can buy. For those who might not be familiar with the research, can you talk about what has made them so good at offsetting inflation?
Schwartz: And you see that this year with all the inflation that’s in the system, you tend to see companies raising prices. So, they’re passing along price increases. They’re even sacrificing volume. One of my friends is using the term “price over volume.” You see it in a lot of the earnings reports that companies are pushing price and even sacrificing volume. And that goes to, over time, companies are really good long-term inflation hedges. And as you say, in the book we show that long-term real return to stocks, that real return is after inflation. That 6.7% we quoted very early on when we talked about capital market expectations, 6.7% was the return above inflation. So, if you go back in Siegel’s 200 years of data, the first 130 years, there was basically no inflation. And then, you’ve had 70, 80 years of inflation. And over the 200 years, inflation has been down about 1%, but over the last 80 years, there’s been inflation about 3%. And what you find is that the real return to stocks was basically over the very long periods the same exact with inflation as when there was no inflation. So, you didn’t see your real return go down at all with the inflation that we’ve experienced.
Bonds, by contrast, historically didn’t have any inflation-adjusted bonds. The real risk to bonds was that there’d be higher inflation and that the coupons wouldn’t offset that. But in the short run, when the Fed starts battling inflation and hiking rates like they did last year—last year was a bad year for both stocks and bonds, first bad year for stocks and bonds in a very long time. In the short run, as the Fed starts fighting, it can be painful for stocks. But over the long run, as you see companies pass along price increases, they’re what we call real assets, they tend to grow earnings and dividends along with inflation. If you go back to that original S&P study that we started the interview with, the S&P dividend growth since 1957 has been about 2% on top of the 3.7% inflation. So, you get real growth on top of the inflation hedging that you get with the fundamentals offsetting that. And so, that’s part of why we view stocks as the best long-term inflation hedge.
Ptak: Maybe to ask a quick follow-up on that. When you did your research, I would imagine, one of the things that you did was try to decompose what it was that made stocks the good inflation hedges they were. And I suppose there’d be a few sources you mentioned. One is dividends. The other two ostensibly would be multiples. You could get some multiple expansion and then also earnings growth, whereby there would be some pass through of the price increase, and they would be able to deliver higher earnings as a result and it would somewhat offset the price pressure.
So, when you went through and you try to decompose it, what did you find? Was it the case that maybe the market sniffs out inflation ahead of time, they sell off stocks, the multiples get nice and low, and you get multiple expansion in the years since and that helps you to hedge some of the inflation? Or was it a combination of that and maybe their ability to pass price increases along?
Schwartz: I think each period is going to have—the short-term time periods are definitely dictated—more of the volatility comes from valuation adjustments than underlying earnings growth. But over the real long run, it’s the earnings growth that drives the return. So, I think, if you go back that 50-plus years, most of the return was dividend yield plus dividend growth, not most of it was valuation. You could decompose it to probably roughly 3% average dividend yields, much higher in the first part and much lower in the second part. Now you’re closer to 1.5% on the S&P 500. But back in the ‘50s, ‘60s, ‘70s, you got above 3%, well above it. So, call it, 2.5% to 3% average dividend yield going back to the history of the S&P, and it was about 6% dividend growth. That’s roughly 8% to 9% of the returns coming from fundamentals, very small amounts from valuation over the long run.
You could say now you might think valuations need to compress. We’re not in that camp. We think valuations are fair and normal today at a little bit below 20 times. What we actually think are the new equilibrium-type P/Es that are warranted. But you could add or subtract the valuation change in the future over the long run. In the short run, all sorts of things can compress or expand on what’s happening in that environment. Right now, people are worried about earnings collapsing with the recession or the recession that never comes. But everybody is worried about the recession, what’s going to happen to earnings. I gave a view on what could support earnings on the dollar coming out later this year. And I think one of the reasons earnings haven’t gone down so much is the dollar being weak in the last six months. But those earnings risks are, in a recession, you should pay up for it. You shouldn’t apply depressed multiples at depressed levels of earnings. You could arguably justify a 22 P/E instead of like a 16 P/E. But the bears out there today are saying, hey, it’s not going to be 200 on the S&P, it’s going to be 180, and then we’re going to apply a 16, 17, or even lower, whereas we think you should apply a higher multiple. So, that’s a little bit on the short-run versus long-run valuation question.
Benz: Going back to the idea of stocks as an inflation hedge, I think that one of the issues consumers and investors wrestle with when it comes to inflation is that they don’t have a long enough time horizon to make stocks a suitable inflation hedge. This is especially true of retirees who are interested in preserving their purchasing power. So, what’s the next best inflation hedge that they should consider?
Schwartz: What you couldn’t do historically, and why bonds had a 30-year negative return, is that bonds didn’t have any built-in inflation hedges built into them. And so, in that 30-year stretch where you had very high inflation and rising interest rates coming to the peak around 1980, you had this negative return for bonds. If you go back a year ago, 12 months ago, you had negative inflation-adjusted bond yields, and people were locking in. They’re giving the government $100 and taking $90 back after inflation, which was kind of crazy where you were at the beginning of last year.
Yields have risen dramatically from the bottoms. And you’re now about 1.5% on the 10-year TIPS bonds. So, if you really are afraid of inflation, you can get this 1.5% coupon plus the inflation adjustment. That is a much lower risk than traditional bonds in that sense. So, that’s probably the next best thing. There’s a cost to that. If you’re going to hold a stock for 10 years versus hold the TIPS bond for 10 years, I think you’re going to do well better in the stock. If you’re not looking at the price volatility day to day, like you said, the retirees might not have the stomach to hold the stock for 10 years without looking at it, and they want the bond with a lot less volatility. I think at 1.5%, it’s probably fair value. We talk a lot about how the future bond returns are likely to be lower. The demographic trends, population trends on there and productivity combined gives you a lower real economic growth. That means lower real interest rates. So, at 1.5%, it may be approaching good fair value on TIPS. I think that’s probably the next best.
I think the other place, if they did want a little bit more risk than beyond that 1.5% coupon you’re getting in TIPS bonds, I do think energy stocks, now they’re more volatile places of the market, but they are the cheapest sector in the market, 10 times earnings. Energy is one of those places where inflation shows up. I think they’ve been acting as one of the few diversifiers to core S&P stocks. It’s certainly one of the biggest risks is that there’s more inflation causing, again, declines in stocks, declines in bonds. I do think as a sector, that’s one of the sectors that I think offers an interesting play to hedge inflation also.
Ptak: Maybe we can shift and talk about dividends, which is a perennially popular topic with Morningstar.com users and our listeners. You’ve done a lot of work examining the source of returns and wrote recently that you’re a fan of investing in high-quality businesses that grow dividends. Why high-quality and why dividends?
Schwartz: Why dividends is almost like, well, why should you be investing in stocks? It’s for the ultimate cash flows that you get off of them. So, what are the cash flows from stocks? They are dividends. You could say these nonpayers, like a Buffett that I quote so highly, he’s been a nonpayer. Why is he special? He talks about not everybody’s a capital asset allocator like he is. In his world, he’s bought back shares when he considers his stock very cheap and can manage that. He does it for tax reasons in many places. But there are a lot of tax-insensitive investors as well who can be just like Warren and not worry about the tax that they have to pay on their dividends. So, there’s definitely a group that don’t want to pay the taxes on dividends, and there’s a group that can take it and do it. Ultimately, the nonpayers, you’re believing that earnings are going to grow faster and that the market will reward you for that growth versus, hey, if you got a dividend, you know what the underlying cash flows of the business are and what you’re getting from that.
High quality came from, as we were thinking about it, we first launched broad dividend weighting and high-yielding. There was a number of people who looked for dividend-growth strategies, and a lot of people who looked backward to identify growers. There was an Aristocrats index that had a 25-year lookback when we first launched. They narrowed it to 20 years because of concentration concerns. There was an index called the Achievers that went back 10 years of consecutive increases. I looked at Apple paying, and I saw its capacity to pay. And I said, one of the first year Apple might get added to the Achievers index? This year, in 2023, when it first started paying in 2012. And I said, it’s probably one of the fastest dividend-growers for the next 10 years. Why would you want to wait 10 years? You need to look forward. So, you go back to the academic literature, and you study the dividend discount model and all the CFA textbooks, and they showed the price is equal to dividends over R minus G—cost of capital and the sustainable growth rate. Then they teach that the sustainable growth rate is return on equity times earnings retention. And you say, so how profitable your company is, the marginal reinvestment, how much you reinvest will lead to sustainable dividend growth. And return on equity is one of those factors in all of the high-quality indexes. You look at MSCI’s quality index, they have a return on equity-type variable combined with leverage. We talk about Buffett when he often talks about high-quality businesses, high return on capital businesses. That’s where they’ve had some of their single best winners over time, was these high-quality businesses—even at good fair prices, better than buying more junky value, junky being low profitability, low return on capital businesses. So, that reinvestment, that return on capital is what leads to sustainable dividend growth. That’s one of the reasons why we launched our quality dividend growth family. Just past its 10-year anniversary this week, actually. And so, we’ve been doing high-quality dividend-growth strategies for the last 10 years. It’s also been doing quite well since we launched it.
Benz: Can you talk about what quality looks like in the financial services sector and also address whether the events of recent months with several notable bank failures, whether that’s altered the way you and your team define quality?
Schwartz: It’s a great question. And I continue to think about this question all the time. We have added new risk models to some of our strategies over time where we’re trying to identify the highest levels of risk and uses. Some of that, we added a momentum factor to that to say, are you just buying value traps? These banks looked fine not so long ago until they didn’t. So, I think it is a very interesting question.
I still believe some of the challenges for banks will remain in many ways. When you look at their deposit rates that they’re paying on checking accounts, many of them are not paying what you can get in short-term Treasuries. If you get 5% plus in the shortest-duration Treasuries with one week duration, your bank is not paying you that. And now, they’re sort of late, and they think their deposit, what’s called the deposit beta, of how much money will rush to these money market funds and others—they thought it was going to be low, and this new mobile banking world is presenting new challenges.
I think it’s an interesting question. I think the profits at banks will be interesting to see. Are there more competition for checking account-type vehicles? And they have a much more difficult profit scenario going forward. So, I don’t say I have a short answer on what quality looks like today. I think it’s one that we’re going to have to keep answering. But I do think the small regional banks have trickier issues than the larger banks. Right now, you haven’t seen any real issues for the large banks. They’ve been benefiting from the deposit flight to—at the initial safety questions from Silicon Valley Bank and the others—move deposits to the large banks. But the profitability of the large banks may also get squeezed a bit as more people say, why aren’t they passing along the 5% I could get in Treasuries?
Ptak: We’ve talked a little bit about foreign stocks during the course of this conversation, but I wanted to drill on a little bit further. You recently co-wrote a piece describing how some of the active strategies WisdomTree offers reduce their China weightings to lower the idiosyncratic risk those investments court. Can you talk about how you model idiosyncratic risk and what gave your managers reason to question whether the market had fully impounded that risk into the stock’s price?
Schwartz: I think this is going to be one of the big questions over the coming years is your China allocation. You’ve seen more people launch emerging-markets ex-China. MSCI has an index for that, and you’re seeing some interest in that. We had launched a fund last year for emerging markets ex-state-owned, ex-China. You look at where China was in indexes when, call it, two decades ago is less than 10%. You got up to almost 40%. You’re now down at a third. And there’s increasing just unique risks. A lot of geopolitical tension that does not seem to be going away, and it’s not a small allocation in people’s portfolios at a third of these broad indexes. The issue is, in broad indexes, people also don’t like to take out-of-benchmark bets. So, going to zero, it is an active strategy in one of them that you talked about. Another one has a just more constrained weighting toward, call it, 10% versus zero. It has to do with the process of both those funds.
I think there’s, one, just going to be increased demand for looking at China differently. It’s part of our assessment that the risk to China is not going away, and if anything, could get heightened over the coming years. When you look at the characteristics before lower China and after lower China, all the great things—this is one of those quality dividend-growth emerging-markets strategies—there were some unique things about emerging markets that we wanted to be active to begin with, that some of the data you were looking at was one of more flexibility in how we did some of those growth screens, some of the earnings estimates weren’t quite as robust when you went to EM as you had in U.S. large-cap space. So, there was a reason why it started off active.
Then, as we looked at the different risks going around now, we thought this was an opportunity with the ex-China version having all the same great valuations, it’s close to single-digit P/Es, it’s still very high return equity premiums over the market, still good dividend-yield premiums versus the market, but it has this one less big risk overhang of what’s going to happen in China. I think it will be an interesting testament of how it performs over time. People are going to want to look at it both versus emerging markets generally and emerging markets ex-China. People can then control how much China risk they want. I think a lot of people like that it’s hidden as a line item within a broader emerging-markets allocation. In some ways, it forces the question, how comfortable are you with China? Do you want it as a stand-alone? Do you want to overweight it? Do you want to not have it? It will become an interesting question. But in some ways, a statement that we don’t think the risks are going away. We’re going to have to think about it in other strategies over time. It will be interesting to see the feedback that we have for that fund in particular.
Benz: You and a colleague recently did some interesting research on emerging-markets value. It’s fared quite well despite the fact that value has once again lagged growth in developed markets. You came to a somewhat surprising conclusion, which is that value stocks benefit more than growth during periods of accelerating growth. Can you explain that?
Schwartz: Well, even this year, you look at the performance of the U.S. market in 2023, and it’s been a return to the mega-growth stocks leading and value lagging and what do you think is happening there? It’s the recession risk in many ways. As people worry about recessions and earnings decline, the more cyclical sectors, which tend to be more value sectors—you could say energy is an example, financials have their own unique cyclical risks. But the more economic sensitivity, more of their earnings, and if you think about P/E ratios, if you have a 10 P/E like energy does, your current earnings are one tenth. If you have a 30 P/E, your current earnings are only one third of your value. So, the higher your P/E, the more you don’t care about what happens to earnings this year, ironically. The lower your P/E, the more you care about the current outlook for earnings, as that’s a bigger driver of your valuation, the overall stock there.
Now, emerging markets, we talked about, has been one of those places where I talked about how high dividends has been a classic thing that worked over the last 15, 17 years since we’ve been launching those. So, it’s been a good long-term factor, but also because a lot of the China tech stocks were the ones that are big weighting in cap-weighted indexes—they suffered due to some of the China tech crackdowns themselves. So, some of the dividend yields worked particularly well over the last two, three years for emerging markets.
Ptak: We’ve talked quite a bit about public equities. Maybe we can quickly shift and talk about private equity. My question for you is whether you think private equity is a bubble, and if so, does it burst in the typical way? Or do you think it enters a long malaise, like Japan did?
Schwartz: Well, Japan was probably the largest bubble of all time, or at least one of them, where you had its weight ballooned in the broad markets. Its dividend yield collapsed to 50 basis points. The whole market was around 100 P/E. And so, the Nikkei has been deflating from the most expensive market internationally, and the biggest weight internationally, to now it’s with a value approach, you get 10 times earnings in Japan. A very different story today versus where it was. It’s breaking out to 30-year highs, funny enough.
In terms of private equity, I think some of the challenges, now you’ve got rates rising, and so versus the environment the last few years, they got used to be funding deals at zero rates, and the cost of things were very, very low. So, it was somewhat a beneficiary of the very ultralow interest-rate environment, and so they applied a lot of leverage on deals. Rates are higher, so they’re going to bid lower. In a way, I don’t think it’s a “bubble” there. I think there are definitely a group of people who like not seeing the statements mark to market every day. There’s all sorts of comments about—they look at lower volatility just because they’re not valuing it every day, just like your house. If you got a quote on your house every day, you’d think it’d be a lot more volatile than it actually is. But I think they have new challenges from the higher borrowing rates, but they had to deal with that historically before the last 10 years, and they’ll deal with it again. It’s just going to be what price are they willing to pay given their much higher borrowing costs. The valuations ultimately will come down in a lot of those businesses, and that’s manifested in some of the public markets as well.
Benz: We wanted to ask about ESG. WisdomTree offers several ESG products as well as a series of ESG model portfolios. We’ve had some ESG skeptics on the podcast—most recently Aswath Damodaran—and they criticize ESG for the lack of evidence that it actually improves financial or nonfinancial outcomes. What research did you conduct that gave you confidence that your products would improve financial or perhaps nonfinancial outcomes?
Schwartz: And this is another chapter of Stocks for the Long Run. I encourage people. We added an ESG chapter to the latest edition of the book. So, we have a lot of good stuff in there on how to think about ESG as a category and what drives returns. There is some evidence that people are willing to pay up for ESG-sensitive, whether it’s a bond or a firm, and pay higher multiple. If it has a higher multiple, you come back to my early comments about multiples driving returns. If it has a higher multiple, that means a lower forward expected return, unless you think those multiples are going to rise or that you expect the earnings are going to grow faster because they’re doing certain ESG things. So, it comes back to unexpected changes in demand, better-than-expected profits as the financial outcomes, or is there a group of investors who do just demand that and have some of these nonfinancial interests there that cause their preference shift to favor those types of stocks?
We’re a global firm. We have a strong presence in Europe. I’d say we’re trying to be thinking globally and acting locally, but there is definitely a very big divergence between European investors, clients, our team versus U.S. investors, and including the regulators. In Europe, it’s a requirement basically for us that we have to have ESG screens on everything, frankly. In the U.S., you have some specific strategies for that, trying to think, again, globally and have some overlapping synergies in our investment approach, but there is different appetite in Europe versus the U.S. The question is, is Europe leading or not? But Europe is definitely highly, highly demanding these types of things, both screens and they have what’s now called Article 9, that you have to be intentional in your screens to get the outcomes you’re looking for. So, a lot of interesting things, but I do think Europe is one of the places where it’s a very different look than in the U.S.
Ptak: For the last question, I think we’ll widen the aperture a little bit, so to speak. I was curious about a topic of debate, an investing or financial matter at your firm right now, where you are the contra, maybe you’re the lone voice in the room that’s advocating for a particular position. What is that issue you’re the contra on these days?
Schwartz: I think it probably comes back to the thing I talked about early on the show, when you asked about the risk that investors are paid to take and not paid. In some ways, some of our models have battled this own question about currencies and I think make the same mistakes some of what I say our clients are making, which is that the benchmark dictates what’s the active risk or not. And the problem is, there’s a local currency benchmark, there’s a fully hedged benchmark, there’s an unhedged benchmark, and our models have also used the unhedged benchmarks. And the switching of benchmarks becomes a whole question. And then, you start saying, well, do we want to take the active risk or not? And very few times, will you have a strong conviction on, “Oh, yes, it’s going to be a very strong dollar environment,” versus my view of, “Hey, people shouldn’t be taking this risk; they’re not paid to take it.” But it gets into this circular conversation. So, I’d say it comes back to the currency question, which is, I’ve been out there for a long time for decades saying people take too much currency risk. I still say it, and we’re probably guilty of it ourselves and our models benchmarking to the unhedged ETFs.
Ptak: Well, Jeremy, this has been a very enlightening discussion. Thanks so much for sharing your time and insights with us.
Schwartz: Appreciate it. Thanks for having me.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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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