Enrich Your Future 06: Market Efficiency and the Case of Pete Rose

Andrew Stotz 00:02
Hello fellow risk takers, this is your worst podcast host Andrew Stotz, from a Stotz Academy, and I'm here today with Larry swedroe, continuing our discussion, Larry's got three decades, as Head of Research at Buckingham wealth partners, you can learn more about his story in Episode 645. Larry is unique because he understands the academic research world, as well as the practical world of investing. Today, we will discuss a chapter from his book enrich your future, the keys to successful investing. And the chapter is number five great companies do not make high return investments, Larry, take it away.

Larry Swedroe 00:43
Yeah, this is kind of an anomaly for people have a hard time understanding, because they think the whole idea of investing is to identify a great company, and therefore you would get great returns. But if you understand finance, that really doesn't make any sense. And the first basic rule that we've discussed about Andrew, is that something that you know, is only information, it's not value added information, unless the market doesn't know it, because that information is already embedded in the price through the trading actions of all of the marketplace investors. So here's a good way, I think, to think about the problem. Let's do a little exchange here. There are two big retailers in the United States are two of them. One of them is Walmart, let's everyone I think would consider that to be a great company. And let's say it was trading at a market capitalization of 20 billion. Okay. And let's say this is another company called Kohl's, which is also a department store. You know, it's a company, it's not downgrade, you know, and it was also trading at a market valuation at 20 of 20 billion, even though it has much less earnings, a much weaker balance sheet, you know, doesn't have, you know, all the technology that Walmart has in place all the management, you know, you can go through every kind of item you could think about, and when comparing the two, everyone would likely agree Walmart is better. Could that world exists, then, where both companies were trading at 20 billion?

Andrew Stotz 02:41
Doesn't seem like it could exist, right?

Larry Swedroe 02:43
It's not logical. So let's look at a more logical example. Let's say Walmart was trading at a 500 billion valuation. And Kohl's was trading at a $5 billion valuation. So Walmart is trading at 100 times the value, because it's a much better company has much better earnings, stronger balance sheet, all those things we talked about. Now, Andrew Stotz is a pretty smart finance guy. And he says, You know this Walmart's a great company, it's trading at 500 billion, let me make an estimate of the future earnings. I can even do that by looking at analysts forecasts of earnings take the consensus number. And if I have to pay a market cap of 500 billion, I run the numbers, I get an expected return of 10%. Now you take coals with a market cap of 5 billion, much lower earnings, of course. But when you run the numbers and go through the same exercise, because the valuation is lower, even though the earnings are lower you to come up coincidentally, with the exact same 10% expected return. Now we know expected returns are just that they're not guarantees that you might think of them as the mean of a wide potential dispersion of potential outcomes. Okay. So if you had that same expected return, which company do you think you should invest in?

Andrew Stotz 04:25
Well, it seems like Walmart should be growing faster, bigger, stronger and more profitable.

Larry Swedroe 04:32
Well, that's true, but that's already in your numbers in your numerator there, which is your expected earnings that's there. Then you have a denominator is the discount rate you use to discount those earnings. And you came up when you had that as higher expected. Let's say we thought Walmart earnings would grow 10% and coal would grow too. And when you ran the numbers coincidentally they came on With the same expected 10% expected return, so you have to make a decision now, which companies should you buy?

Andrew Stotz 05:10
So I think most people are going to say, Well, I'm gonna buy Walmart because I can buy it at 10 times, and it's a higher quality company 10

Larry Swedroe 05:19
times your it's the same 10% 10 10%

Andrew Stotz 05:23
expected return, I would think that I should get a higher return from from Walmart, maybe that

Larry Swedroe 05:30
market knows that it's got that it's built it so you end up with the same 10% expected return. So I'll help me out here, Andrew, I'm trying to figure out which stock I should buy. Well,

Andrew Stotz 05:44
in that case, if everything is factored in, and they both have a 10%, return, expected return. So the market has factored in the levels of growth, the levels of profitability, and all their expectations of risk and all of that, and they should be equal.

Larry Swedroe 06:03
Nope. Okay. All right, there's you should definitely have a preference because in that potential dispersion of returns, you're looking at it we right, we have to discount the future earnings growth. And I think you would agree because Walmart is a much better company with a stronger balance sheet and all these other advantage, which is the less risky investment should be Walmart. Well, if you get the same expected return of 10%, would you buy the less risky Walmart and get an expected to end? Or would you buy calls, which maybe goes bankrupt, or maybe they bring in a new CEO when it turns around, and they grow much faster than the market fence. So you have to decide, have I got the same expected 10% return? I want to buy this safe for company, right? So that world should not exist. Walmart's price has to be even higher, to make up for or to get me interested to buy Kohl's instead of Walmart. So investors would come in and sell Kohl's to buy Walmart driving Walmart's price up. But the earnings are the same. Now maybe I get a 9% expected return or eight or some of them. And calls price goes down until the risk adjusted expected returns of the same. And maybe it's 12% expected return for Kohl's versus eight for Walmart. And that discount of 4%. And the expected return is enough to incentivize me to buy call because now the risk adjusted expected returns have the same it's the way to think about this as simple analogy. If you could buy the debt of Walmart, let's say it's issued corporate bonds for 20 years. Well, Walmart's bonds might be rated A or double A. And calls might be rated triple B or C the yields are not going to be the same right? Yep, clothes will have a higher yield. So that must be because it's riskier, well then this same thing must be true of the stocks, because stocks are riskier even than bonds. So the discount rate you're going to use on Walmart has to be lower than the discount rate. Now that let's say the expected return was 12% for Kohl's a value company trading at a low p e multiple, because it's riskier, and the discount rate was 8% for Walmart, because it's a safer growth company, which is a better investment.

Andrew Stotz 09:11
Now now, I'm not sure I I'm not exactly sure tell me Larry,

Larry Swedroe 09:17
the answer is neither. They both have the same risk adjusted returns right let's say we think calls is 50% riskier and so it's got a 50% higher expected return 12 versus eight. If the market thought the risk adjusted return of calls was better. Well then this smart guys at you know hedge funds and renters would, you know selling call to buy Walmart if right and vice versa. And then the market would move until you got an equilibrium and risk adjusted returns. So if you believe that the MA concern efficient, which we discussed, it's not perfectly efficient. But the odds of you beating the market a solo, you should assume it's efficient enough, right that you shouldn't try? Well, then all risk assets, when you adjust for the risks of those assets should have very similar risk adjusted return. So the right answer is don't engage in individual security selection. Because there you can diversify, and get the same risk adjusted returns. But with a much narrower dispersion of potential outcomes. You own the s&p 500, you have a bell curve that looks like this, you own one stock, the standard deviation is probably twice that of the market. So you're twice as much risk for the same average expected return for any individual stock. So

Andrew Stotz 10:58
when someone says it's cheap, for reason, do they mean that the reason is, is because it's cheap, because it's incorporating a higher level of risk, higher

Larry Swedroe 11:08
level of risk, higher level of uncertainty, whatever it might be, might be facing greater competition in his favor, because its product is more commodity like it could be have a higher leverage, from a financial perspective, it might have more operating leverage means it's more susceptible to recessions, because they have high fixed costs. And they can't lay people off or shut factories down all those things. So that's how the market operates. It incorporates everything, now we'll move about a stock, getting it into that discount rate. And the discount rate is the risk premium of it's the risk free rate, which is T bills plus a risk premium, that's your denominator. And the numerator is your expected earnings. So it doesn't matter, it's completely irrelevant. What the earnings number is, in terms of your expected return, your expected return is always the discount rate. The numerator drives the present value or the current price. So with the same discount, right, if you have higher earnings, all you do is you have a higher price, you don't get higher earning higher expected returns, because you have five earnings that's set by the discount rate. And

Andrew Stotz 12:37
if you look at the overall market, and let's say the average return to the overall market has been 10% per year, let's say, take a number like that. And then you say to yourself, Okay, I want to understand how do I risk adjust that return? How do you do that one market level?

Larry Swedroe 12:55
Yeah, so what you could do is look historically, and let's say T bills have averaged 3%. And so the market got 10, at least on a compound basis, you've got a 7% risk premium for taking the risk of 1973 for when stocks dropped 50%, the risk of 2000 to 2002, when they dropped 50%, the risk of 2008, etc. That's the risk premium, you're you know, you can earn for accepting that big fat left tailed skewness risk. The stocks basically never go up 50% In the year, but they do go down 50% Sometimes. And

Andrew Stotz 13:42
so when I see that premium, let's say going from 7% to let's just say 3%. Yep. So it's a big difference. And I think you talked a little bit about the idea of kind of trying to understand a little bit about when you're at peaks, and when you're at bottoms. What would I read from that?

Larry Swedroe 14:02
Yeah, so what happens is when the discount rate is going down, that means the P E ratio, price to earnings ratio is going up. So you can a simple way to think about it is to use what's called the cape 10. Okay, which looks at cyclically adjusted earnings over a 10 year period to kind of smooth out highs and lows because we want to look at longer term data. Okay. So it turns out that over long periods of time, worthless over the next one or two years, but if you invert the K, the P E ratio, you get an earnings yield, that's the circulator Justin P E ratio. So historically, stocks have averaged a P E of about 16. Now invert that for Me, Andrew, and what yield or earnings yield do come up with 16. What is it? 16 into 100? And about seven? I'd say okay, coincidence, we got a 7% risk premium. Okay. All right. Now what happens when the P E goes to 20? Well, now what's the risk premium? Now it's 5%. Right? Now, it turns out that on average profits, but when you get euphoria, and the P e is like in 99, go to 40. Well, now your earnings yield is two and a half percent or maybe even went to 50. and the NASDAQ stocks, they were 100. Now you have much lower expected returns. And inversely, okay, when the cake 10 is low, the earnings yield is low, like in the middle a depths of recessions. Okay, in 2009, maybe the PE dropped to eight, or something like that, now you got a 12 and a half percent real return expected to stocks, okay, or risk premium roughly equal to about that. So now, that doesn't mean that stocks are a good buy when the earnings yield is low. And stocks are a good buy, good sell when the earnings yield is high, and there's almost no correlation over the next 12 months. Over the next 10 years, even their correlation is about 40%. So that's telling you it's a lot, but it still means there are wide potential dispersions of outcome. So when the P e is say 20, the median is five, but there's still a good chance you may get a six or seven or eight or even a 10. Okay, present return, but there's also a chance you're gonna get four, three, or two or minus two. And as the yield goes up, all that curve does is it shifts one way or the other. So a higher earnings yield means the curve is shifted to the right, meaning your median expected return is now higher. And the reverse is true, when the earnings yield goes down now are everything the mean is low, but you can still get an, you know, a six or 7% real return. Like in 98, the cape 10 was very high. But 99 in the market went up 28%, about 2001 and two are not so pretty. So you can't really use it the timing. And what I tell people is this, what you have to understand is you need to build a plan that incorporates the fact that when earnings yields are low, you need to expect low returns, and that adjusts your asset allocation accordingly, to make sure you have a good chance of achieving your goals, when that's the case, doesn't mean you necessarily change your asset allocation per se, you may need to decide, well, you know, stock returns are going to be lower, I need to save more now, or I need to lower my goal or adjust that because I don't want to take more risks. Alternatively, you could say I really want to retire at 65, I'm going to have to put more money into stocks, at the same time recognizing that the expected return is now lower. And you have to incorporate the same thing with bonds when bond yields are higher. You don't need to take as much equity risk if real yields are high, because you're getting a higher expected return from the bond. So you need less than your equities. So that's how you want to use this is mostly in that way is to build a plan and decide how much you need to save. Invest, how much would be stocks and bonds. The last thing I would say is don't try to time this or I'll emphasize that. The only thing I will say is this if you're going to sin, and by that I mean trying to time the market, one do it only at extremes. So the ease of 2022 three, I probably wouldn't do anything except make sure your plan incorporates that now lower expected return. But at 40 PS, boy that's getting tempting to say especially if tips yields which are risk free are say 3%. So I'm getting a higher real return expected from tips than stocks. Then I might say I might take a bigger position or let's cut some equity risks to do that. That's what I did basically in nine In Da, I, you know, got out of the asset classes that were trading at very high fees, I just moved to an all value portfolio, because value stocks were trading at Pease of 12, not 40. And there's two questions

Andrew Stotz 20:16
I want to ask before we wrap up. The first one is, what's interesting about talking to you is that you most people in the market talk about PE, and you talk about expected return. You know, and I'm just curious, like, what is the source of that? Is that because you think about it differently, or is it coming from an academic side? Or, you know, it just, it's interesting?

Larry Swedroe 20:37
Yeah, well, you know, you talk about P E, because that's the common language. But you have to understand that a higher P E doesn't mean a higher expected return. Right? It may mean that you're paying a high price for high expected growth and safety, because the company is a really strong company. Right? So you have to you can't think of that P E. Now, high P doesn't mean it's a bad investment, necessarily. Right? Yep. And my view is the markets efficient. And I think all risky assets have similar risk adjusted returns, until we get to these bubbles, which, you know, really extreme valuations.

Andrew Stotz 21:26
And the last question is, when we talk about risk, adjusted return, we talked about like calls and Walmart and looking at stocks and things like that. A lot of people when they talk about risk, they oftentimes refer to volatility, let's say, a standard deviation or something like that, when you're talking about risk. Are you talking about that? Are you talking about something different? Well,

Larry Swedroe 21:47
risk is one measure of side volatility is one measure of risk. But it's not the only measure of risk. Okay. And to use technical terms, we have skewness and kurtosis, which are that towels. So you can think of a lottery ticket. Right? You know, it's left skewed, meaning most of the returns to the left of the mean, right? 95% of the lottery tickets lose money, but it's got a big fat right town. Right? That's where everyone likes them are many people like to buy lottery tickets, right? So that's a problem. People like the opportunity to hit that homerun. Right. So you have to think of volatility Plus, these, you know, are you willing to accept that stocks are left skewed? You know, the bad returns are larger than the good returns? Right, we can go down 40 50%, you know, but you don't tend to see that, right. But the reason you get high stock returns is you have to live with that really bad left tail risk that correlates with your labor capital. So it's like getting laid off is what we have to think of there. And then there's even another risk, which we've talked about, in some cases called liquidity. If you need to get assets and turn it into cash quickly, say you own a rubber plantation in Indonesia, not very liquid, I can pick up the phone and say sell my shares. And next day, I get the cash or two days later, I get the cash, you might be spending a year in negotiating right. So illiquidity is another risk, right, and mock credit, risk, duration, risk, these are all things that have to be considered. And that's what the market does in its infinite wisdom is it is taking the collective wisdom of the market, incorporating it. So the only time you really should be taking, you know, positions, if you will, and betting against the market is because you have a different risk profiles in the market. So I'll give one simple example. Okay, I am now 72 years old, I have to take out of my IRA accounts, what's called a required minimum distribution, which is about 5% of my assets. Okay. Now, I can own illiquid assets, assets that pay that allow you to take out 5% A quarter at a minimum, but that may be the most you may be able to get out. You may be aware, your listeners may be familiar with the travails of Blackstone, and now ESRI star Woods REIT and KKR Azeri where they got gated If, and they wouldn't distribute out more than 2% in any month and 5% in order.

Andrew Stotz 25:06
So they got gay, did you mean the gay,

Larry Swedroe 25:10
okay, so you and I know a million dollar investment in, you know, in Blackstone's REIT, you could get out 20 grand a month, and for two months, and the third month only 10. Now, you still got another guy's got 950,000 and you want out, but you can't get it. So that's an ill acquitted asset. So it's gonna have a premium. And I don't care because I don't need more than 5%. That's all I'm required to take out and I have other assets. So I can get at least 20% a year. So I can say, like the Yale endowment and Harvard and others, who is spending only five or 6% a year maybe of their endowment, I can invest in a lot of illiquid assets earn that premium, because for me, that's not as risky as it is for the average investor. So I should overweight assets, that, for me, are less risky. So I'll give you another example. If you're a construction worker, you're highly susceptible to the economic cycle risk, you probably shouldn't own deep value stocks that are very cyclical, because they're gonna have low prices in the middle of recession, and you get laid off and you've got to sell stocks to put food on the table, you're selling at the worst possible time. But I didn't have that risk. So I could have more exposure. So I would own more value stocks, not because I think value stocks are higher risk adjusted returns, I think, a higher expected returns, but not once you adjust for those extra risks, but I don't have that risk. So I can overweight, that risk. So that's the way investors can build portfolios, they should favor assets that are risky to the average person, or in aggregate, but not so risky to them.

Andrew Stotz 27:20
So that's a great discussion on this, this chapter of great companies do not make high return investments. And I'm looking forward to the discussion of chapter six, which is market efficiency in the case of Pete Rose. And for those people that don't know, Pete Rose, he was a famous baseball player and later a coach and gotten involved himself in a little bit of a scandal, right,

Larry Swedroe 27:44
betting on his own teams and stuff. And we'll talk about his track record and betting when he had inside information of betting on his own teams. Can't

Andrew Stotz 27:55
wait. Well, Larry, I want to thank you for another great discussion about creating growing and protecting wealth. And I'm looking forward to that next chapter. And for listeners out there who want to keep up with all that Larry's doing. Just find him on Twitter at Larry swedroe Or on LinkedIn. This is your worst podcast host Andrew Stotz saying. I'll see you on the upside.