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Rob Arnott on AI Mania: Lessons From the Dot-Com Era · Merryn Talks Money

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Speaker 1: Bloomberg Audio Studios, Podcasts, Radio News.
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Speaker 2: Welcome to Meren Talk's Money, the podcast in which people
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Speaker 2: who know the markets explain the markets. I am Meren
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Speaker 2: Sumset Web. Now. This week we welcome back to the show.
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Speaker 2: Rob Arnott. Rob is founder and chairman of the board
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Speaker 2: of Research Affiliates are research intensive asset management firm. Now, Rob,
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Speaker 2: I've asked you back on for a couple of reasons.
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Speaker 2: First because we always have really interesting chats, and I
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Speaker 2: know that the listeners super enjoyed the show that we
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Speaker 2: did last time. But also because the question that we
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Speaker 2: get asked the most on the show out and about
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Speaker 2: everywhere we go is is there an AI bubble? And
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Speaker 2: if there is spoiler alert, almost everybody thinks there is.
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Speaker 2: What do I do? What do I do now? You
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Speaker 2: wrote back in March, you wrote a great report about
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Speaker 2: this about you know, whether this is a bubble or not,
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Speaker 2: comparing it to the dot com bubble, looking at in
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Speaker 2: a wider context, etc. There was quite a few months back,
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Speaker 2: and that was at the point when it looked like
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Speaker 2: things were cracking slightly. Right. Since then, if it is
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Speaker 2: a bubble, it's an even bigger bubble. And one thing
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Speaker 2: that we do know is that whether there is a
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Speaker 2: bubble in AI or not, there is definitely a bubble
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Speaker 2: in people asking us questions about whether there is a
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Speaker 2: bubble in AI, and in politicians and eccentral bankers and
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Speaker 2: supernational organizations looking at you the IMF suggesting that there
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Speaker 2: might be a disorderly correction as we you'phemistically like to
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Speaker 2: call these things at a later date. So all this
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Speaker 2: is going on, which is why I thought you Rob
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Speaker 2: of a perfect guest. So Rob, welcome to Meren Talks Money,
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Speaker 2: Thank you onwards. So let's start then with that report
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Speaker 2: that you wrote in March, and am I okay to
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Speaker 2: put a link to that in the show note so
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Speaker 2: everyone can look at themselves later.
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Speaker 3: Yeah, of course, absolutely, please please propelling.
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Speaker 2: Okay, So there will be a link to this report
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Speaker 2: in the show notes so everyone can read it in FULD.
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Speaker 2: But let's start with talking about that. Basically, what you're
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Speaker 2: doing is you're comparing it to the dot com bubble,
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Speaker 2: which really was a proper bubble and obvious bubble from
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Speaker 2: so long in advance and back then we looked at
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Speaker 2: that bubble, all of us and said, well that's a bubble.
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Speaker 2: But we couldn't tell you when it was going to burst.
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Speaker 2: So one of the things you do is you compare
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Speaker 2: the AI bubble, which going to call it a bubble
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Speaker 2: for shorthand here the AI bubble with that bubble. So
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Speaker 2: let's talk first about what's similar, what is the same
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Speaker 2: between these two situations.
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Speaker 3: You've got froth evaluations. You've got to spread and valuation
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Speaker 3: between growth stocks and value stocks. That's become to borrow
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Speaker 3: the British term ginormous uh, and it's uh. You've got
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Speaker 3: to spread and valuation between large cap and small cap stocks.
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Speaker 3: That's at w reck extremes. Now. One of the things
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Speaker 3: that people say now that they also said in the
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Speaker 3: dot com bubble is this isn't a bubble, this is real.
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Speaker 3: Back then, they said the Internet is going to change everything.
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Speaker 3: It'll change how we buy and sell goods and services.
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Speaker 3: It'll change how we get our news, how we do
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Speaker 3: our research. It'll change how we interact and network with friends,
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Speaker 3: with family, with clients. It's going to change everything. And
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Speaker 3: these are the dominant players and they're going to build
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Speaker 3: our future. Most of that was true.
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Speaker 2: All of the first bet was true, right, all of
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Speaker 2: the first bet.
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Speaker 3: Yes, Now where the narrative failed is that newcomers came in, competed,
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Speaker 3: and the leading players weren't all leading players ten years later.
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Speaker 3: In fact, the ten most valuable tech stocks in the
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Speaker 3: world coming into the year two thousand, z ro out
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Speaker 3: of ten beat the S and P over the next
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Speaker 3: fifteen years. You had to wait eighteen years for one
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Speaker 3: Microsoft to actually edge past the S and P. Eighteen
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Speaker 3: years is a long time to wait. The other things
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Speaker 3: that happened were the adoption of the Internet happens slower
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Speaker 3: than the advocates expected. The adoption of AI is happening
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Speaker 3: slower than the advocates of this revolution suggest. So the
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Speaker 3: narrative AI will change everything, My goodness, it absolutely will.
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Speaker 3: It's breathtaking. Anybody who's used chat GPT five, it's astonishing
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Speaker 3: how intelligent it is. We wrote an article fundamental growth
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Speaker 3: that's on the Internet and is likely to appear at
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Speaker 3: a journal early in the new year, and we gave
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Speaker 3: it to Chat GPT five point zero and said, tell
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Speaker 3: us what's good and bad about this paper. Tell us
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Speaker 3: where there's repetition we can trim, tell us whether there
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Speaker 3: are references or citations that we missed. It gave a
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Speaker 3: two page summary of the paper that was better than
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Speaker 3: anything I or Cam Harvey or the other authors could
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Speaker 3: possibly have written. Beautiful, wonderful synopsis. Then it gave us
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Speaker 3: a rundown of ways to improve the paper. We took
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Speaker 3: most of its suggestions. Then it gave us a list
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Speaker 3: of ten citations. We missed four of them. We looked
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Speaker 3: at them and we thought, wow, why didn't we think
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Speaker 3: of that? Yes, put it in. Four of them were
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Speaker 3: more borderline. We ignored them. Two of them didn't exist.
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Speaker 3: So it still hallucinates. It creates stuff out of thin air,
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Speaker 3: which is something that you've got to be very careful about.
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Speaker 3: But it's breathtaking. The leaders of the AI revolution our
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Speaker 3: leaders today. Will they be disrupted? Disruptors get disrupted. Think
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Speaker 3: of the most valuable tech stocks in the world in
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Speaker 3: two thousand, Microsoft, It went through it off decade, and
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Speaker 3: then it regained its footing and became the world leader
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Speaker 3: that it is today, Cisco. Cisco's chairman in March of
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Speaker 3: two thousand said, I don't see why we can't grow
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Speaker 3: forty percent a year. As far as I can see,
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Speaker 3: forty percent a year means you're going to get be
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Speaker 3: six times as large in five years. How big are
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Speaker 3: they now? They're six times as large. It took twenty
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Speaker 3: five years.
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Speaker 1: Not five.
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Speaker 3: Yeah, it's a yeah.
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Speaker 2: This is exactly the kind of thing that we hear
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Speaker 2: from Nvidia, which by the way, as we're speaking, has
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Speaker 2: been hitting new highs. Exactly the kind of thing we
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Speaker 2: hear from them, that this growth can go on indefinitely.
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Speaker 3: If you can find power stations to power. I read
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Speaker 3: somewhere that's something like five percent of the US power
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Speaker 3: supply is now used by AI, and they're wanting it
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Speaker 3: to double every year for the next three years. Well,
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Speaker 3: that would take it to forty percent.
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Speaker 2: Yeah.
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Speaker 3: There's a wonderful paper by Aschenbrenner, one of the co
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Speaker 3: founders of Open Ai, called Situational Awareness, that talks about
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Speaker 3: the future of AI. And it's wonderful because it's so
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Speaker 3: insightful on how many ways it can change the world.
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Speaker 3: It's off target in a couple of ways. He says,
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Speaker 3: we need to increase the power generation capability of the
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Speaker 3: US grid by forty percent by twenty twenty seven. Well,
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Speaker 3: maybe we should, but it's not going to happen.
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Speaker 2: And even of course, if you manage to increase the
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Speaker 2: power going into the grid. Making the grid resilient enough
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Speaker 2: to carry that huge increase in power would be verging
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Speaker 2: on impossible, and a timeframe like that, right, So there
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Speaker 2: are power constraints on AI, there are regulatory constraints on AI,
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Speaker 2: maybe ethical constraints on AI. And then I guess it's
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Speaker 2: also the case if we stick with this comparison to
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Speaker 2: the dot com bubble and possibly even too maybe even
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Speaker 2: the smart the smartphone boom or whatever you like to
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Speaker 2: call it, in from two thousand and seven on, it's
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Speaker 2: around that Chinese competition, which didn't exist in quite the
8:09
Speaker 2: same way in the same volume. Then we've moved, we've
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Speaker 2: moved from the similarities to the differences too quickly. That
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Speaker 2: was what I meant to do, but we've done it.
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Speaker 2: So there's more competition, global competition that suggests that maybe
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Speaker 2: first mover advantage isn't quite what it might have been,
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Speaker 2: and maybe there's a first mover disadvantage or there certainly
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Speaker 2: there certainly was in the dot com bubble.
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Speaker 3: Yeah, well, rounding out the top five back in two thousand,
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Speaker 3: you have Intel, who was that disrupted? Good lord, yes,
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Speaker 3: you've got Nokia. It still makes phones. It was fifth
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Speaker 3: most valuable company on the planet. Back in two thousand,
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Speaker 3: you've got loosened. Loosen doesn't exist anymore. I mean, it's
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Speaker 3: it's a graveyard. And the other part that's just fascinating
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Speaker 3: is March of two thousand, when the bubble burst. Roll o'
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Speaker 3: clock forward two years, the Nasdaq was down fifty percent
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Speaker 3: on its way to an eighty percent drop Russell two
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Speaker 3: thousand value. Remember, value was trading cheap. Small cap was
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Speaker 3: trading cheap again, same thing today, Russell two thousand value
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Speaker 3: was up fifty three percent in those two years. The
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Speaker 3: bull market of the nineteen nineties for most stocks didn't
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Speaker 3: end until March of two thousand and two, and that
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Speaker 3: was two years into the bursting of the bubble. The
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Speaker 3: big cap indexes were dragged down, but the median stock
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Speaker 3: was up for those next two years. The same thing
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Speaker 3: could play out today. I'm not predicting that, but what
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Speaker 3: I am saying is that decoupling of frothy large cap
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Speaker 3: popular names from very successful mainstream businesses in valuation can
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Speaker 3: mean revert and I think likely, Well.
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Speaker 2: Well, you say can mean revert historically always have mean
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Speaker 2: reversal correct, which doesn't mean that it happens this time
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Speaker 2: and doesn't tell us when it might happen. But there
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Speaker 2: has never previously been a point when this kind of
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Speaker 2: disparity has not reverted to a historical mean of some kind.
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Speaker 3: Yeah, here's a fun factoid. Members of the S and
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Speaker 3: P five hundred or of the Russell one thousand are
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Speaker 3: at valuation multiples that are two and a half times
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Speaker 3: as large as non members. Now people will say, yeah,
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Speaker 3: that's because these are wonderful companies and these aren't pardon me,
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Speaker 3: over the last thirty years, roll o' clock back thirty
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Speaker 3: years they were at parody. They were about the same
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Speaker 3: valuation multiples. So they blew out one hundred and fifty
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Speaker 3: percentage point gap opened up. These guys. The non members
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Speaker 3: have had earnings and dividend growth one percent a year
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Speaker 3: faster than the members. Oh so they're better companies on
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Speaker 3: average that are valued at forty percent the valuation multiples
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Speaker 3: of the index members. We have a short paper membership
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Speaker 3: has its privileges that's in draft form that examines this difference,
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Speaker 3: and it just points out the obvious that if you're
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Speaker 3: a member of the index, membership has its privileges, you
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Speaker 3: are entitled one to a higher valuation multiple. Because you're
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Speaker 3: a member two, you're entitled to steady inflows of capital
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Speaker 3: propping the price up and holding it higher. And both
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Speaker 3: of those facts are realities of today's market. Indexing has
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Speaker 3: really swamped the markets and has compromised the price discovery
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Speaker 3: mechanism of figuring out what companies are actually worth.
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Speaker 2: Yeah, the point being that, because of the rise of
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Speaker 2: passive investing, companies automatically get flows every time anyone buys
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Speaker 2: an index, so the differentiation between between the valuation of
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Speaker 2: stocks becomes most least.
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Speaker 3: That's exactly right.
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Speaker 2: Okay, But here we are, and I think you know,
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Speaker 2: we're already talking ourselves into agreeing that this is a
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Speaker 2: bubble and that it shows all the characteristics of a bubble.
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Speaker 2: And then we have the few things we haven't discussed,
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Speaker 2: like the insane levels of concentration in the US market
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Speaker 2: any global we've been at and global markets, so we've
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Speaker 2: been at concentration levels like this before. Have we been
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Speaker 2: quite the highest? I think we have been near these levels,
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Speaker 2: but it's always a massive danger sign, not even not
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Speaker 2: even near.
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Speaker 3: No, this is the highest concentration in global and particularly
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Speaker 3: US because it's US concentration that leads to the global concentration.
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Speaker 3: I mean, the US is two thirds of the world
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Speaker 3: stock market. It's three fourths of the developed world stock market.
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Speaker 3: So it's the magnificent seven thirty percent of the US
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Speaker 3: stock market. They're twenty percent of the world stock market,
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Speaker 3: these seven companies. And yes they're magnificent. Yes they have
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Speaker 3: product that everybody wants. Yes they have product that everyone needs.
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Speaker 3: Yes they're reshaping the future of the world. But this
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Speaker 3: is a competitive landscape. Look at Intel. I mean, even
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Speaker 3: the Chips Act couldn't save Intel, and a fifty billion
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Speaker 3: dollars infusion from the US government could couldn't help it
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Speaker 3: defend itself against the rise of Nvidia, because in Nvidia
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Speaker 3: disrupted them. And disruption is normal. Disruption happens regularly in
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Speaker 3: a healthy capital economy. Creative destruction is a real thing.
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Speaker 3: If you are behind the curve, you're going to lose
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Speaker 3: business and lose market share and be pushed aside. And
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Speaker 3: that's actually a good thing. It means that the better
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Speaker 3: ideas get a chance to gain traction and grow. And
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Speaker 3: these seven companies are all disruptors and are all very
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Speaker 3: powerful in their industry, but none of them is immune
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Speaker 3: to competition, and Vidia has already a number of organizations
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Speaker 3: lapping at their heels with new super chips that are
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Speaker 3: in some ways better than in videos, and Video got
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Speaker 3: a head start which was tremendous. The story behind that's
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Speaker 3: also fun. Jensen Wang said, these super chips that we're building,
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Speaker 3: let's save some real estate on them and just not
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Speaker 3: fill it with circuitry because the next round of circuitry
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Speaker 3: is going to be better and we won't have to
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Speaker 3: redesign the whole chip. Who builds a chip with dead
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Speaker 3: space in it? It was a stroke of genius. It
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Speaker 3: allowed them to plunk in the new, better stuff faster
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Speaker 3: a year or two faster than they would have otherwise.
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Speaker 3: And boy, what a stroke of genius. So these are
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Speaker 3: brilliant companies. That was his disruption of the whole silicon industry.
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Speaker 2: I suppose one thing we should just say and side
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Speaker 2: is that it's not the concentration in itself that is
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Speaker 2: necessarily a problem. In the UK, stop market is also
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Speaker 2: very concentrated, doing a very large percentage of it is
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Speaker 2: just our biggest stocks. But part of the problem with
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Speaker 2: this concentration is the correlation. So they're all in the
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Speaker 2: same industry, all in the same business and if you
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Speaker 2: look at the UK market, for example, while we have concentration,
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Speaker 2: the big companies are generally and in different businesses. So
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Speaker 2: it's both things, the concentration and the correlation between them, right,
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Speaker 2: and the business connections between them.
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Speaker 3: Of course, here's a couple of fun factoids. The market
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Speaker 3: value of the Magnificent Seven was twenty trillion at the
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Speaker 3: end of September. That's bigger than all stock markets in
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Speaker 3: Europe combined. That's bigger than all of the Chinese stock market. Basically,
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Speaker 3: the market's value for a company is supposed to be
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Speaker 3: the market's best gas at future profit distributions back to
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Speaker 3: the shareholders discounted back to today, so the net present
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Speaker 3: value of future profits. What the market is saying is
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Speaker 3: that the future profits of these seven companies will exceed
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Speaker 3: all profits generated by all of Europe, bigger than all
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Speaker 3: profits generated by all of China. Is that possible? Yes?
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Speaker 3: Is that likely? I don't think so. These companies compete
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Speaker 3: against one another, and Vidia's fifty percent profit margins are
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Speaker 3: not going to continue more than two or three more
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Speaker 3: years because competition is coming into play. If they're roll o'
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Speaker 3: clock forward ten yures, if they are forty percent of
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Speaker 3: the super chip market instead of ninety, if their profit
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Speaker 3: margins are still a robust thirty percent not fifty. If
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Speaker 3: the pricing power means that revenues per chip are down
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Speaker 3: by two thirds over the next ten years, and that's
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Speaker 3: probably conservative. Plug those into a spreadsheet and what you
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Speaker 3: find is okay, goodness, Their two and thirty five profits
16:54
Speaker 3: are going to be no better than their twenty twenty
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Speaker 3: five profits, and yet their priced is if they're going
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Speaker 3: to see stupendous growth. Pallunteers another fabulous example. How many
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Speaker 3: companies get to be priced at triple digit multiples of sales,
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Speaker 3: not of profits. It peaked at one hundred, one hundred
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Speaker 3: eighty times sales. So with sales last year of two
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Speaker 3: to three billion, they were they're worth about four hundred billion. Now,
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Speaker 3: how do you justify four hundred billion market cap when
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Speaker 3: your sales are two to three billion. The only way
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Speaker 3: to do it is to have those sales grow to
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Speaker 3: twenty billion, forty billion, one hundred billion and profits to
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Speaker 3: match and do that fast enough. Is that possible? Yeah?
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Speaker 3: Is it likely? I don't think so. So I see
17:47
Speaker 3: bubbles galore. I also see some very profitable, highly successful
17:52
Speaker 3: companies priced it premium multiples, but not nosebleed levels. And
17:59
Speaker 3: so I think there's a lot of stocks in this
18:02
Speaker 3: bubble that are not nonsensically priced. And yeah, that's a
18:08
Speaker 3: good thing. That's a healthy side of the market.
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Speaker 2: Okay, I get this my feeling that you don't think
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Speaker 2: it's quite ready to burst yet. We're not quite at
18:19
Speaker 2: you know, Cisco levels.
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Speaker 3: Well, some of them are at Cisco level. Cisco crested
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Speaker 3: it in early two thousand, one hundred and eighty times
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Speaker 3: earnings and pallunteers way past that.
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Speaker 2: But I just want to read that one of the
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Speaker 2: sentence that you write in this report, which I think
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Speaker 2: kind of sums up everything you're saying, which is a
18:41
Speaker 2: very simple, fast developing sectors writing waves of innovation and
18:45
Speaker 2: optimism are inherently volatile, which is what you mean when
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Speaker 2: you talk about the regular disruption of these things. And
18:51
Speaker 2: one of the extraordinary things about a bubble is that
18:54
Speaker 2: inside the stories that people tell themselves inside a bubble,
18:58
Speaker 2: that the general narrative that there is no volatility, there
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Speaker 2: isn't competition, there isn't the disruptors remain the disruptors. They
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Speaker 2: do not become the disrupted. That's how the story works exactly.
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Speaker 2: And the thing that tends to break these bubbles is either,
19:12
Speaker 2: you know, well, it's either it's a change in the
19:13
Speaker 2: cost of capital, it's a change in the wider environment,
19:16
Speaker 2: or it's the realization that the narrative doesn't include the
19:19
Speaker 2: next wave of disruption.
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Speaker 3: Yeah, and people talk about the jobs lost. Every technological
19:26
Speaker 3: revolution since the industrial revolution has destroyed millions of jobs.
19:31
Speaker 3: The thing is that painful to those whose jobs or
19:37
Speaker 3: whose families members' jobs get destroyed. Yes, do people care
19:43
Speaker 3: about those job losses a generation later?
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Speaker 2: No.
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Speaker 3: The thing that is different is that the computers will
19:51
Speaker 3: be more intelligent than we are in the not too
19:54
Speaker 3: distant future. In some ways, they already are. My CEO,
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Speaker 3: Chris Bright likes to play with AI every weekend for
20:04
Speaker 3: three to five hours, testing its capabilities, and he had
20:07
Speaker 3: a conversation with GPT five about how AI fits in
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Speaker 3: the realm of human evolution, and it gave a discourse,
20:17
Speaker 3: short discourse that was so insightful you'd think it was
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Speaker 3: from a double PhD in anthropology and philosophy. And it
20:27
Speaker 3: closed with the observation, we don't know yet whether human
20:32
Speaker 3: intelligence and machine intelligence will merge, or whether human intelligence
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Speaker 3: will at some stage be a fond and distant memory
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Speaker 3: for AI. And then it closes with the sentence the
20:48
Speaker 3: wonderful thing in this revolution is that we get to choose.
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Speaker 3: And I thought, who the heck is we?
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Speaker 2: Well, that's an interesting question, isn't it who we? In
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Speaker 2: this context? I don't think it's me. It might be you,
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Speaker 2: but I'm not feeling like it's me.
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Speaker 3: But anyway, existential threat, Yeah, do I worry about that?
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Speaker 3: I don't because I try to worry about things I
21:14
Speaker 3: can have any influence over. This revolution is coming and
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Speaker 3: it's big. But who's going to be the disruptor in
21:21
Speaker 3: the coming decade? Who will be the market leaders ten
21:24
Speaker 3: years from now? Some of market leaders today will be
21:28
Speaker 3: the market leaders in ten years. Some won't. They're all
21:32
Speaker 3: chrisd as if they will be the market leaders.
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Speaker 2: So I think where we are now is that we
21:50
Speaker 2: are agreeing that we are at the very least in
21:54
Speaker 2: bubble territory, that valuations are in bubble territory, that there
21:59
Speaker 2: is not enough understanding of the next round of disruption.
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Speaker 2: One thing we haven't mentioned, actually is the extent of
22:06
Speaker 2: the capex and the extent which AI capex is crowding
22:09
Speaker 2: out everything else in the US, and when stuff gets very,
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Speaker 2: very capex heavy, of course, if you do get disrupted,
22:16
Speaker 2: you're in a whole lot of trouble, right. I mean,
22:18
Speaker 2: a lot of the dot com bubble with very capex light,
22:22
Speaker 2: and same with smartphones, platforms, et cetera. Capex light. But
22:25
Speaker 2: this is pretty capex heavy.
22:26
Speaker 3: I'm glad you mentioned that. One of the fascinating facts
22:31
Speaker 3: about growth stocks is that R and D is positively
22:38
Speaker 3: and reasonably strongly correlated with future growth for companies. I mean,
22:43
Speaker 3: it's not perfect. You can waste money on R and
22:45
Speaker 3: D just like you can waste money on anything else.
22:48
Speaker 3: Capex spending is negatively correlated with future growth. Really surprising.
22:53
Speaker 2: We don't tell the AI found that.
22:56
Speaker 3: Well, here's an example. In a healthy capitalist system, happy
23:02
Speaker 3: customers are the essential component of success. If you're going
23:06
Speaker 3: to succeed, you must have happy customers who value your
23:09
Speaker 3: product more highly than what you charge for it. In
23:13
Speaker 3: Vidia has happy customers. They line up for the privilege
23:16
Speaker 3: of getting on a waiting list to buy massive quantities
23:20
Speaker 3: of super chips. In Vidia's customers have yet to figure
23:24
Speaker 3: out how to monetize that capex. They're having trouble figuring
23:28
Speaker 3: out how to earn money on AI And so is
23:32
Speaker 3: that going to happen? Yes, it will, But is it
23:37
Speaker 3: happening fast enough to support the prices of these stocks?
23:41
Speaker 3: Probably not, And therein lies one of the key challenges.
23:45
Speaker 2: Okay, So add that infa mix, and we could say,
23:51
Speaker 2: when you wrote this back in March, you said, and
23:53
Speaker 2: maybe we're in nineteen ninety seven, maybe we're in the
23:56
Speaker 2: late nineteen nineties, or maybe we're right on the edge
23:59
Speaker 2: of that nasty that beginning of two thousand. We can't
24:01
Speaker 2: be sure. It sounds like you would put yourself closer
24:04
Speaker 2: to the late nineties at the moment.
24:06
Speaker 3: No, No, I would. I would say that we're more
24:09
Speaker 3: likely to be near the cusp than not.
24:12
Speaker 2: Now, okay, we say, let's put ourselves at November ninety nine.
24:16
Speaker 2: You want to do that, Sure we're in November ninety nine.
24:18
Speaker 2: If we were in November ninety nine, what would be done.
24:22
Speaker 2: The first thing we'd do is we'd sell our Cisco
24:24
Speaker 2: because we've already made pushing three thousand percent on that
24:26
Speaker 2: right then, what would we do?
24:28
Speaker 3: The trick about bubbles is never short them because they
24:34
Speaker 3: can go longer, last longer, and go further than you
24:37
Speaker 3: can imagine.
24:38
Speaker 2: That's what a lot of spread patter is found out
24:40
Speaker 2: in the UK in nineteen ninety nine.
24:42
Speaker 3: And so what you do is you underweight, you fade
24:46
Speaker 3: your exposure to bubbly stocks, and do it gradually. So
24:50
Speaker 3: just let people average in to a bargain, you average
24:54
Speaker 3: out of froth and take take some profits, and do
24:59
Speaker 3: it gradually and take your time at it because you
25:02
Speaker 3: don't know when the turn's going to happen. The same
25:03
Speaker 3: thing works when it comes to bargains. We're in the
25:07
Speaker 3: only major business in the global macroeconomy where people hate bargains.
25:13
Speaker 3: I mean, imagine if Tiffany's posted a sign saying everything
25:16
Speaker 3: marked down twenty percent before Christmas, and Cartier across the
25:21
Speaker 3: street posts a banner sign saying shiny beautiful stuff for
25:25
Speaker 3: Christmas only twenty percent more than last year, and people
25:28
Speaker 3: flood Cartier and shun Tiffany's. When it comes to retail,
25:35
Speaker 3: people don't behave that way. When it comes to investing,
25:37
Speaker 3: people absolutely behave that way, and so you have to
25:40
Speaker 3: be careful with bubbles. It doesn't mean you have to
25:43
Speaker 3: own them. It doesn't mean you have to fully weight them.
25:46
Speaker 3: So a fundamental index, which we invented twenty years ago,
25:51
Speaker 3: simply reweights the growth stocks down to their economic footprint.
25:55
Speaker 3: It doesn't kick them out. So the Magnificent seven is
25:59
Speaker 3: thirty four percent of the S and P five hundred,
26:01
Speaker 3: but it's eighteen percent of RAFFI. It's it's big, it's
26:06
Speaker 3: very big, but it's not thirty four percent. And so
26:11
Speaker 3: that's one tool in our tool kit. Fundamental index.
26:14
Speaker 2: Explain that a bit further, because you know, you've been
26:17
Speaker 2: known before, and they'll be some listeners you understand completely
26:20
Speaker 2: about your fundamental indices, and they'll be others who simply don't.
26:23
Speaker 2: So tell us a little bit more about how that works.
26:26
Speaker 3: We came up with a strategy twenty years ago called
26:29
Speaker 3: RAFFI Research Affiliate It's fundamental index. Instead of choosing companies
26:33
Speaker 3: based on their market value, the more expensive they are,
26:35
Speaker 3: the more likely they are to be in the index,
26:37
Speaker 3: we choose stocks based on their economic footprint. How big
26:41
Speaker 3: is their business? What are their sales as a percentage
26:44
Speaker 3: of all public companies? What are their profits as a
26:47
Speaker 3: percentage of all public companies? If it's a big enough business,
26:50
Speaker 3: it's included. And then it's weighted by the fundamental size
26:53
Speaker 3: of the business.
26:54
Speaker 2: And what do we mean by fundamental size of the business.
26:56
Speaker 3: Well, just as an example, what are the sales of
26:58
Speaker 3: Nvidio as a percentage of all companies in the world.
27:02
Speaker 3: It's a fraction of a percent, but it's close to
27:06
Speaker 3: five percent of world stock market capitalization. And so it's
27:11
Speaker 3: this big a company, it's this big in market cap.
27:14
Speaker 3: Fundamental index says, thanks for that lovely gain, I'm going
27:17
Speaker 3: to weight you down here. It doesn't say I'm going
27:19
Speaker 3: to kick you out. And so fundamental index is one answer.
27:24
Speaker 3: So fundamental index has two interesting attributes. It downweights the
27:28
Speaker 3: gross stocks. It upweights the value stocks. It gives you
27:31
Speaker 3: a stark value tilt. Always value has been terrible for
27:34
Speaker 3: fifteen years, so why would you want to do that?
27:38
Speaker 3: Because it also has a rebalancing alpha. If a stock
27:42
Speaker 3: sores and the fundamentals of the company don't validate that rise,
27:46
Speaker 3: RAFFI will say, thanks for the nice gain, I'm going
27:48
Speaker 3: to trim you. The market's constantly changing its price on
27:51
Speaker 3: what a company's worth. You're concratrating against those whenever they're
27:55
Speaker 3: not validated by fundamental changes in the scope of the business,
28:00
Speaker 3: and so that contratrating is a source of incremental return.
28:04
Speaker 3: So the cool thing is that RAFI globally has beat
28:09
Speaker 3: global value indexes by over two percent a year since
28:13
Speaker 3: the launch of RAFI twenty years ago, and has beat
28:17
Speaker 3: value indexes in roughly three out of every four years.
28:21
Speaker 3: There's hardly anything out there with that kind of consistency.
28:24
Speaker 3: And if you're able to steadily beat value by two
28:28
Speaker 3: two and a half percent a year and win three
28:30
Speaker 3: years out of four, then to the extent you want
28:34
Speaker 3: a toe hold in value as a safety net for
28:38
Speaker 3: your portfolio, why would you do it any other way?
28:41
Speaker 3: So this represents one of the possible answers.
28:45
Speaker 2: It's interesting, isn't it, because when you talk about the
28:47
Speaker 2: divergence between value and value and growth to the extent
28:50
Speaker 2: you can make this distinction value and growth, and also
28:53
Speaker 2: the divergence of value were seen between large and small caps.
28:56
Speaker 2: The tempting thing for most investors, or certainly investors with
28:59
Speaker 2: mone inclinician, is to go pure value, go pure small cap,
29:04
Speaker 2: et cetera. But I think what you're explaining is that
29:06
Speaker 2: that doesn't really work because you have to wait so long.
29:10
Speaker 2: Very often, you know your weight can be years. Suddenly
29:13
Speaker 2: this time around, there have been little moments where you think, oh,
29:15
Speaker 2: look it's back. Value's back, active management is back, etc.
29:18
Speaker 2: Then and then suddenly often the video goes again, and
29:21
Speaker 2: you know the value investors don't looks are great again.
29:23
Speaker 2: So you know your weight can be very very long
29:28
Speaker 2: for a pure value investor.
29:29
Speaker 3: Your weight can be very very long for any style
29:32
Speaker 3: that's out of favor. Growth has been out of favor
29:35
Speaker 3: for long stretches of time, and we haven't seen that recently,
29:41
Speaker 3: and so folks with less gray hair than me will
29:44
Speaker 3: often say, yeah, but that was that was ancient history.
29:48
Speaker 3: Growth hasn't had any troubles in the last fifteen years,
29:51
Speaker 3: absolutely true, But history has a knack for repeating, if
29:56
Speaker 3: slowly and if imperfectly. And when you get to these
30:00
Speaker 3: vast spreads and valuation two and a half to one
30:03
Speaker 3: between members of the index and non members eight to
30:08
Speaker 3: one between growth and value measured on price to book
30:11
Speaker 3: value twelve to one for growth versus value measured on
30:15
Speaker 3: price to sales ratios twelve to one, that's extraordinary. And
30:20
Speaker 3: so when we look at today's markets, you see things
30:25
Speaker 3: very very stretched. You see a narrative that explains why
30:29
Speaker 3: they deserve to be stretched, But narrative set prices. You
30:33
Speaker 3: don't make money by betting on a narrative. You make
30:35
Speaker 3: money by finding where the narrative might be missing something.
30:38
Speaker 3: And what it might be missing is competition.
30:40
Speaker 2: Yeah, what about a pure equal weighted index? So you know,
30:44
Speaker 2: most most passive investing takes place in market cap weighted
30:47
Speaker 2: in disease, which is why you end up with such
30:49
Speaker 2: a bias towards the bigger equities. And so if you're
30:52
Speaker 2: investing passively at the moment, the reason you have such
30:55
Speaker 2: enormous exposure to the Magnificent seven and to America is
30:59
Speaker 2: because you are You're doing this on a market weighted basis.
31:01
Speaker 2: But there's a good argument to be made for the
31:04
Speaker 2: regular automatic rebalancing that comes with a pure equal weighted index.
31:09
Speaker 3: It's interesting. Equal weighting has been around for a long
31:11
Speaker 3: time and it works for the very patient investor. It
31:16
Speaker 3: gives you a stark small cap tilt because the big
31:20
Speaker 3: cap stocks are being reweighted down, and it gives you
31:25
Speaker 3: a relatively deep value tilt. But it's alpha engine is
31:30
Speaker 3: the same as Raffi's, same as fundamental index for stock sores,
31:35
Speaker 3: you're going to trim it with RAFFI. If the stock
31:38
Speaker 3: sores and the fundamentals don't, you're going to trim it.
31:40
Speaker 3: But if the fundamentals rise with the price, you're going
31:43
Speaker 3: to be perfectly happy and stay of the course. Yep,
31:47
Speaker 3: RAFI has the advantage relative to equal weighting of firstly
31:52
Speaker 3: working a little better. It's about one hundred basis points
31:55
Speaker 3: per anum better performance. Secondly, it still buys large businesses,
32:01
Speaker 3: and so large businesses are often large cap, so it
32:05
Speaker 3: doesn't have the stark small cap tilt that equal waiting does,
32:09
Speaker 3: and therefore it has huge capacity. Equal Waiting if it
32:13
Speaker 3: was run on globally on one hundred billion dollar scale,
32:17
Speaker 3: would run into some serious problems of having to buy
32:21
Speaker 3: more of the smallest stock in the index than exists.
32:24
Speaker 2: Okay, that seems like a reasonable argument against it. Yeah, okay,
32:28
Speaker 2: so so not equal weight or an equal weight. It's
32:31
Speaker 2: an answer, but maybe not the best answer. Going straightforward
32:34
Speaker 2: value not necessarily the best answer. So fundamental index approach
32:39
Speaker 2: that you are using sounds very compelling, and the risks
32:46
Speaker 2: to it.
32:46
Speaker 3: Are The risks to it are very simple. It has
32:49
Speaker 3: a stark value tilt. When value is out of favor,
32:52
Speaker 3: it will struggle to keep up with the market, but
32:54
Speaker 3: it won't struggle to beat value. It beats value relentlessly.
32:58
Speaker 3: So to the extent you want value in your portfolio.
33:02
Speaker 3: Like I said, why would you do it any other ways?
33:04
Speaker 3: It's so compelling, it's so simple, and it's so powerful.
33:08
Speaker 3: That's its biggest disadvantage is the value tilt.
33:12
Speaker 2: Robert, what would make you change your mind about the
33:17
Speaker 2: idea that AI is in a bubble? What would make
33:21
Speaker 2: you go that, you know what, that's worth one hundred
33:23
Speaker 2: and ninety pe or in video, yeah, it's going to
33:26
Speaker 2: grow thirty percent forever. What would make you look up
33:28
Speaker 2: and go, actually, do you know we all go on
33:30
Speaker 2: about bubble. The bubble story is very compelling as well, right,
33:33
Speaker 2: I mean it's compelling as the narratives around bubbles are
33:36
Speaker 2: the fact that there is a bubble that you should
33:38
Speaker 2: avoid and it's all quite exciting, and there'll be a
33:40
Speaker 2: crash and you can be the clever person who predicts
33:42
Speaker 2: the bubble, et cetera. We will want to be that person, right,
33:45
Speaker 2: it's the top Look, they rang the bell. I'm right.
33:47
Speaker 2: Everyone wants to be involved in that bubble narrative too,
33:50
Speaker 2: But what could make us wrong about that?
33:52
Speaker 3: I love your mention of the ringing of a bell.
33:55
Speaker 3: People who buy bubble stocks need to think about one thing.
34:02
Speaker 3: What's my cell discipline? What would prompt me to sell?
34:06
Speaker 3: Will I hear a bell chime that says now's the time?
34:10
Speaker 3: If not, fading your exposure gradually over time has the
34:17
Speaker 3: benefit of not having to wait for the bell, and
34:20
Speaker 3: has the drawback of you will look and feel like
34:22
Speaker 3: an idiot until the turn happens. None of us likes
34:26
Speaker 3: to feel like an idiot. As for what would make
34:29
Speaker 3: me think, gosh, this isn't a bubble, it's that the
34:33
Speaker 3: fundamentals actually catch up to the price, and to some
34:37
Speaker 3: extent that's been happening. In Vidia's profits and sales swored
34:42
Speaker 3: and continue to surge strongly, But it is priced to
34:47
Speaker 3: reflect an expectation of, oh, let's say twenty thirty percent
34:52
Speaker 3: growth per annum for the next decade, and that's a stretch.
34:56
Speaker 3: That's a lot of growth for a long time. It's
34:59
Speaker 3: not impossible, but it is implausible in a marketplace where
35:05
Speaker 3: competitors are coming onto the scene with new super chips
35:09
Speaker 3: that in some ways are better than in NVIDIAs, and
35:13
Speaker 3: so at a minimum they're going to see that fifty
35:16
Speaker 3: percent profit margin come down and the ninety percent market
35:19
Speaker 3: share come down.
35:21
Speaker 2: For those who aren't interested in index investing a school,
35:24
Speaker 2: who aren't interested in straightforward indices or fundamental indices, et cetera.
35:29
Speaker 2: Where do you see value? I mean small caps? Obviously
35:31
Speaker 2: you've said we like to think there's a lot of
35:34
Speaker 2: value in the UK market despite our appalling politics and
35:37
Speaker 2: miserable economy, that UK is.
35:39
Speaker 3: A value market.
35:43
Speaker 2: You say that it's a bad thing.
35:44
Speaker 3: I don't think it's a bad thing at all. I
35:47
Speaker 3: think UK stocks over the coming decade will soundly outperform
35:51
Speaker 3: US stocks. US stocks have to deliver growth well ahead
35:57
Speaker 3: of what we've seen historically and well ahead of the
36:00
Speaker 3: rest of the world. Now that narrative is out there,
36:05
Speaker 3: the American exceptionalism story, Okay, is there American exceptionalism. We're
36:12
Speaker 3: not smarter than Europeans or East Asians. We do have
36:16
Speaker 3: less regulation than Europe and punitive regulation that treats success
36:23
Speaker 3: as a bad thing, impedes success and impedes growth. So yes,
36:28
Speaker 3: that element of exceptionalism I think is slightly true. We're
36:32
Speaker 3: over regulated, but not to the extent that Europe is.
36:35
Speaker 3: But be that as it may. Does it make sense
36:39
Speaker 3: for the US to be three fourths of the developed
36:41
Speaker 3: world stock market? I don't think so. Does it make
36:44
Speaker 3: sense for seven companies to be twenty percent of world
36:48
Speaker 3: stock market capitalization? I don't think so. This does represent
36:54
Speaker 3: an unusually concentrated, in frothy market. I think that European
36:58
Speaker 3: stocks broadly are cheap, relatively attractive. They're cheap for a reason.
37:03
Speaker 3: The narrative tells us exactly why they deserve to be cheap,
37:07
Speaker 3: and the narrative is partly true. Emerging markets are they're
37:12
Speaker 3: going to have better growth than us. Yeah, they're just
37:17
Speaker 3: imitating us and borrowing ideas from us will allow them
37:20
Speaker 3: to course.
37:20
Speaker 2: And no correlation between growth and stock markets, we know that, right, correct?
37:24
Speaker 3: Correct?
37:25
Speaker 2: It's all about where we start. It's all about starting valuation.
37:28
Speaker 3: Starting valuation is low. Fundamental index in emerging markets has
37:32
Speaker 3: a has a PE ratio of eight. If you can
37:35
Speaker 3: buy half the world's economy at a PE ratio of eight,
37:40
Speaker 3: why would you should buy the US at PE ratios
37:44
Speaker 3: in the thirties China? China is now cheap. It is
37:48
Speaker 3: headed by a guy who is a Maoist to the core,
37:53
Speaker 3: and so as long as she is at the helm,
37:57
Speaker 3: if you succeed in China, you'll be punished for it.
38:01
Speaker 3: And if you succeed in China and question the wisdom
38:04
Speaker 3: of the CCP, you're going to be disappeared for it.
38:08
Speaker 3: China is relatively inexpensive today and for the patient investor
38:15
Speaker 3: is probably a goodbye. It probably won't really get out
38:19
Speaker 3: of its way until you get another dang shoping at
38:22
Speaker 3: the helm. Somebody who believes that success is not evil Argentina,
38:27
Speaker 3: I think Malay is marvelous. He's courageous. Anytime you're paying
38:33
Speaker 3: people on government salaries to do more or less nothing,
38:38
Speaker 3: you've got a formula for stasis. And there are lots
38:44
Speaker 3: of government employees everywhere in the world who are doing
38:48
Speaker 3: great work. But when you get a hyper regulated economy. Again,
38:53
Speaker 3: in Argentina, success was seen as evil. If you were successful,
38:58
Speaker 3: you had to have done something wrong and you needed
39:02
Speaker 3: to be punished. That's a terrible attitude for promoting future success,
39:08
Speaker 3: for promoting prosperity.
39:12
Speaker 2: And living standards.
39:14
Speaker 3: All right, Yeah, it is far too common Argentina and
39:18
Speaker 3: Malaya is changing the narrative. I think he's a remarkable man,
39:24
Speaker 3: a little self absorbed, but hey, so are a lot
39:27
Speaker 3: of leaders.
39:29
Speaker 2: Yeah, definitely going to be a little stomach of volatility there, Rob. Listen,
39:33
Speaker 2: I'm taking out too much of your time. I'm really sorry.
39:34
Speaker 2: I promised you thirty five minutes and here we are.
39:37
Speaker 2: This is irresponsible interviewing. But listen, tell me bitcoin. You
39:41
Speaker 2: got any bitcoin in your portfolio? Yes, it's not something
39:45
Speaker 2: for the indices, but you've got something new you do.
39:47
Speaker 3: In twenty thirteen, I was intrigued by bitcoin. I didn't
39:50
Speaker 3: see why it would be worth anything discounted and at
39:53
Speaker 3: present value as zero, But as a libertarian, I thought
39:58
Speaker 3: kind of cool to cut the cut the links with
40:01
Speaker 3: central bankers trying to control everything. And so I went
40:05
Speaker 3: out and I bought a bitcoin. And I still own
40:08
Speaker 3: one bitcoin. I've owned it since twenty thirteen. My cost
40:13
Speaker 3: basis is two hundred and twenty five bucks.
40:15
Speaker 2: Amazing. And and you haven't lost the pass code, have you,
40:18
Speaker 2: not like some other people on this podcast.
40:20
Speaker 3: And I have no intention of selling it.
40:23
Speaker 2: You still have access to your bitcoin.
40:26
Speaker 3: I still have the code to get into my bitcoin,
40:28
Speaker 3: and yes, I could still sell it.
40:30
Speaker 2: Fantastic. I still have the phone that once had the code.
40:37
Speaker 3: Anyway, there's supposedly something like twenty twenty five percent of
40:40
Speaker 3: all bitcoin that is simply lost.
40:42
Speaker 2: Yeah, on holiday with my bitcoin, happy times.
40:45
Speaker 3: Yeah yeah, never to be by anybody. It's just poof evaporated.
40:50
Speaker 2: Yeah, which is of course that one thing that I've
40:52
Speaker 2: always had trouble with a bitcoin. No customer services, no
40:56
Speaker 2: one to call, right, how do I reset my password?
40:59
Speaker 2: Would you like to know the name of my childhood pat?
41:01
Speaker 2: Would you like to know where I went to school?
41:02
Speaker 2: I can tell you my mother's maiden name. Just give
41:04
Speaker 2: me my bitcoin. But doesn't work like that. I'm very
41:07
Speaker 2: naive about it anyway. Listen, moving on from bitcoin gold,
41:10
Speaker 2: you got any golden your put photo?
41:11
Speaker 3: Yes, I have a little gold in a safe at home,
41:16
Speaker 3: and burglars who are watching please don't go and break
41:19
Speaker 3: into my safe anyway. It's there for peace of mind.
41:24
Speaker 3: But it's not a lot.
41:25
Speaker 2: It's enough to sustain the ultimate insurance, right, Yeah, And I.
41:29
Speaker 3: Don't know how good it would be in a financial
41:31
Speaker 3: crisis severe enough that dollar bills no longer worked in
41:35
Speaker 3: credit cards and no longer work, So I don't know
41:37
Speaker 3: that gold would work amazing.
41:39
Speaker 2: Thank you. One last final question, because I'm guessing that
41:41
Speaker 2: you're answered this might be interesting, Rob. What are you
41:45
Speaker 2: reading right now?
41:46
Speaker 3: Ah, this is funny being on a British broadcast. I'm
41:50
Speaker 3: reading a history of the American Civil War. It's a
41:54
Speaker 3: three volume by an historian named Atkinson, who's brilliant writer.
41:59
Speaker 3: And the first of the three is the British are Coming.
42:06
Speaker 2: No one will be frightened these days, and.
42:08
Speaker 3: So it's a fascinating book. It's a dive into the
42:12
Speaker 3: personalities and personal interests and the thinking processes of the
42:18
Speaker 3: people who led both sides of the Revolutionary War.
42:21
Speaker 2: Okay, well, that is a great tip, and I'm sure
42:25
Speaker 2: everyone will rush out to buy them. So I'm not
42:28
Speaker 2: sure they Well, I'm pretty I'm not sure we have
42:30
Speaker 2: that many listeners you will want to go for a
42:31
Speaker 2: whole three volumes, but we'll see, we'll see. Rob. Thank
42:34
Speaker 2: you very very very much for joining us today. Absolutely fascinating.
42:38
Speaker 3: Thank you for reaching out and this has been wonderful
42:43
Speaker 3: fun as always.
42:44
Speaker 2: As ever, ever, thank you thanks for listening to this
42:52
Speaker 2: week's Marrin Talks Money. If you like us, show, rate, review,
42:55
Speaker 2: and subscribe wherever you listen to podcasts and keep sending
42:57
Speaker 2: your questions or comments and marror money at Bloomberg. You
43:00
Speaker 2: can also follow me in John on Twitter or X.
43:03
Speaker 2: Are you on on Twitter?
43:04
Speaker 1: Rob?
43:04
Speaker 3: I am, but I've never actually done it personally.
43:08
Speaker 2: Do you know what your handle is? Rob? What? What's
43:09
Speaker 2: your what's your Twitter name? You don't go, We'll look
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Speaker 2: it up. We'll look it up nowhere about that.
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Speaker 3: It's probably it's probably at Rob or not, but I.
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Speaker 2: Don't know bound to be something like that, right, Okay,
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Speaker 2: As I was saying, you can also follow me in
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Speaker 2: John on Twitter all X, I'm Marinus W and John
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Speaker 2: is John Underscore Stepec. This episode was hosted by me
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Speaker 2: Maren's Unset Web, produced by Sersadian Moses and sound designed
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Speaker 2: by Blake Mabel's and Aaron Caspers. And special thanks of
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Speaker 2: course to Rob. Thank you