TDI Podcast: 10 TEN 10 (#969)

28:57But with all this that's going on and the fertilizer issues, by the way, I saw you saw that note that I wrote maybe, I don't know, three, four weeks ago about my concern about agricultural prices. Right. And all that. I talked to somebody in the business in a restaurant recently. They're buying tomatoes by the case that were twenty dollars per case. now are$70 per case. That's a lot. If you're serving burgers, salads, I don't know, whatever else it may be, that adds up very quickly into a restaurant. Not to mention the fact that you have petrochemical prices going on. We saw that a couple of different companies this week announced that they're increasing the prices by 20 % to 30 % this month and another 20 % next month on their various goods like the chemicals that you put and utilize for packaging.

29:53Packaging is everything. So a lot's happening that I think markets are ignoring, hoping that this comes to fruition. But, Tom, consumers are not. We saw a historic reading just last week, at the end of last week, of the University of Michigan Consumer Confidence. First, what was your comment on that? I think it was down to 47 in the 70 year history of University of Michigan putting this out has never been that low. Number one. Number two, what kind of credence, what kind of weight do you put into that particular? Because for a long time it was pretty heavy people. What kind of weight do you put into that?

30:32And then please tell me what it means. Yeah, I think maybe to start at the end and work my way back is it means that people are concerned. People are unhappy with the situation that they're in. they are generally negative on the outlook for the economy and for their own kind of personal situation. Now, having said that, we would prefer to judge what people do and what corporates do as opposed to what they say, right? And so we would put a little bit less emphasis on consumer confidence, looking at things like retail sales, what they're actually doing. They're continuing to spend money and retail sales are, I would say, fairly strong, actually.

31:19Kind of sitting in the middle there between what people feel and what people do are metrics around intentions of people and businesses. And so on the corporate side, there are some small business optimism indices from the National Federation of Small Businesses that have pretty strong correlations to forward returns, particularly one, small business hiring plans, and then secondarily, small business capital expenditure plans. Those are pretty reliable indicators. And when the small business hiring plans are below kind of both their one year and their five year smoothings or their moving averages, equity returns are essentially zero since 1990.

32:02On the other side, when they are higher, i.e. their expectations for hiring are that companies are going to be hiring. You see stocks returning about 13 % annually. Over the last two months, we've actually moved from one whereby hiring plans were kind of modestly positive to now below those moving averages, which is a little bit concerning. To your point about consumer confidence, small business CapEx plans, That's at the levels that we've not seen since 2009, right after the official end of the global financial crisis. Then how do you explain that we see initial claims at 207? We see unemployment rate miraculously at 4.3.

32:46We see hiring, I think it was, what was it, 177 last month for the, is that the right number? 177 reds? Payrolls was a really nice number. Really nice. How is that possibly, it seems to be conflicting to me. Yeah, 178. You're pretty darn close. It is conflicting, and I don't have a perfect answer for you. And it's one of those things. That's the interesting thing. You know, I know they say that you can't – economics and markets are two separate animals, and sometimes they come together, and it may be more coincidence than it is anything else, right? You know, that idea. But it seems to me, though, and by the way, when I first started in this career and I was looking at indications of what exactly I would be looking at to prepare for the future of what I would be looking at, we created incredible – we still have chart books that we utilize.

33:38We still look at them, but they're just not as useful anymore because the correlation of things like either hiring, firing, GDP numbers, consumer confidence, it doesn't seem to matter. All that matters is if the government is stimulating, if somebody is talking up the markets, and I guess what the Fed is doing. I mean, that's – or take that – the Fed and put that on and overlay that on central banks around the world. Right. And now you have even sovereign wealth funds with unlimited time horizons. There used to be pension funds, but they got themselves in a little bit trouble with things. But you got sovereign wealth funds that have unlimited time horizons that they don't care what price they invest in.

34:25Right. Yeah. So maybe that's all that. I don't know. Let's switch over to the AI trade, shall we? Kind of sauntering over there. Is there more CapEx, I guess, CapEx expenditures for the first, I don't know, the last, we'll call it, better part of what? One and a half year, two years? I'll stretch it out to two years. One and a half years or so, CapEx expenditures, the money that was going to be spent on the buildout of various things, whether it's machinery, chips, whether it's going to be data centers, whether it's going to be electricity, power, unbelievable numbers, right? I mean, astonishing numbers, never been seen before, not even close to what's been seen before.

35:06I heard on Bloomberg just this week, somebody was talking about, he was a really, really smart guy, I thought, and he was talking about the difference between earnings and free cash flow. And the idea that there is going to be, there has been, there's going to be a divide between the two, a chasm between the two that is unlike you've ever seen before because the cap expenditures coming out of free cash flow, a lot of it. Is that a concern? Is that something we need to be worried about? Or is, again, maybe that's something we're looking at, but markets are going to be like, oh, who cares? is for the better good, greater good in the future.

35:43It's going to aid us. It's going to bring in a lot of money. Yeah. Very good question. There's a whole bunch of different kind of layers to that. But, you know, what we've seen is that there's been a massive spend on AI and there continues to be a massive push. And, you know, we were just in a kind of call with our broader team today. And one of the comments that I'll take away that's relevant for this year is that AI, first of all, is part and parcel to our investment processes today. And it's only going to continue to accelerate. And if you don't think that is going to be a big part of what we do, and we're only one small industry, if you will, you kind of have blinders on, right?

36:29And so there has been a little bit of a concern. And this has been going on for as much as like six months from now, particularly with like the hyperscalers, like the Magnificent Seven kind of names that have moved from basically taking a lot of their free cash flow and buying back stock, which reduces the number of shares outstanding and all else being equal, increases earnings per share, right? Artificially. Yes. But it does increase your earnings, you know, to your point about earnings versus cash flow, and to now taking a lot of that cash and putting it to a greater extent into capital expenditures, which doesn't obviously impact earnings per share.

37:17And those capital expenditures take quite a long time to ultimately play out and understand what the return on that investment is going to be. And there are some concerns that it will weigh on, all else being equal relative to what they were doing in the past, weigh on earnings per share. And so we've basically seen a flatlining of the returns of the Magnificent Seven over the last six months or so. They're up like 5 % or so. Having said that, this is kind of like, if you think about like the internet boom, there'll be fits and starts as there were then. We're believers that AI can be transformative.

37:59We've seen this week TSMC come out and kind of with a beat and a raise and guidance that really helps to reinforce the resiliency of AI infrastructure demand. And so while it may take a while to ultimately play out, and we don't know how things will play out until then, the fact is the companies that are beneficiaries of AI are being rewarded a heck of a lot more than companies that are at risk from AI. And so there's a long, short basket. So it's long the AI beneficiaries and it's short those that are at risk. That basket has returned 132 % in the last 12 months. And those beneficiaries don't only include tech companies, but also utilities and industrial companies, energy companies.

39:01And then the short side of that basket, those that are at risk, actually has a higher weight to the tech sector, but it's more weighted towards application software and IT consulting and data processing companies that in some ways may be at risk and some companies could be kind of squeezed out from that perspective. And so we do believe it is transformative, particularly if used in the right way. There are going to be some winners and some losers, but there is a massive build out that is occurring. And it does affect more than just the average technology company. They also saw this week that Google came out.

39:41There was some analysis that showed that they're going to have about$100 billion windfall from the OpenAI IPO when it comes out. That's the embedded value there. And there's other companies too. Microsoft also has a huge position there as well. People knew about that. And then, you know, you go down the list of all the other ones that, you know, you have the Anthropic that supposedly is going to come this year. So we have SpaceX, OpenAI, and Anthropic, right? Those are the three that are supposedly going to suck all the juice out of the markets right now at a full valuation. and I'm going to be so interested in watching the SpaceX IPO that everybody wants to get into, so they believe there'll be a nice pop.

40:23The question is going to be, and by the way, the NASDAQ made room for a five-day window only for them to enter into the NASDAQ 100 index, which is unheard of. And then secondly, what's going to happen when the rug gets pulled when insiders sell that lofty valuation, supposedly 1.7 billion, which is essentially full valuation, which you don't usually have with companies. You get the growth and they just did it all in the background here. Interesting. You mentioned earnings season. We're right in the middle of it. Banks looks like they did pretty well. Wells Fargo is probably the only one that didn't do as well.

41:01They maybe didn't have as much investment trading. The investment work was the biggest side of this. So it's kind of interesting that banks are looking like, and they said, JP Morgan, Jamie Dimon said that it doesn't look like the consumer is really having too much difficulty right now. I think Brian Moynihan from Bank of America also said the same thing. So generally speaking, banks are saying things are good. The yield curve is favorable, not as favorable as it was, but favorable for them. That's a good start. I always find that when banks seemingly start off, everything is all peaches and cream and then just wait a week, just wait a week and things get a little bit crazy.

41:39But that's happening. But that's the value side, right? For a while, we saw the value side, the staples, the utilities, certain healthcare, but not biotech. What am I missing there? Financials and energy. So this was doing really well for a while, then all of a sudden, you kind of go 10, 12 days, you see Microsoft up, I think, 20 % in the last 10 days. You see crazy amounts of returns, Intel, SanDisk, WDC, you mentioned, you know, like even NVIDIA, all, I mean, rounding off the bottom. And I do wonder, by the way, is there something to be said about, hey, we know there's going to be inflationary pressures out there, but how's that going to impact the margins of technology?

42:24Technology, it's not like these guys need, they're not, it's like, okay, hey, Tom, technology company, I'm a buyer. Tom, do me a favor. I need you to ship me X amount of technology. That doesn't go over by train, by plane, by whatever. It just, you know, somehow over the airways. I get it. But the thing here is that maybe that's one of the reasons rotation came back really strong because it seems to be absurdly strong from where it was. But that's the value versus growth discussion. Is this another false start for value over growth? So our models, and we have kind of empirical investors, so we're constantly on the lookout for kind of what factors can be insightful in providing insights as to forward returns across and within asset classes.

43:15So we have kind of a growth versus a value model. It is essentially neutral right now. So, you know, that's kind of a that's kind of a toss up. But here are a couple of data points that I think are really relevant. Growth, for example, if you're just to look at like the Russell 1000 growth index and some of the important sectors like like tech, for example, growth has has has derated. And the NASDAQ, NASDAQ 100, the information technology sector are now trading below their 10 year average multiples. So they've kind of come back from the stratosphere. If you go back a couple of weeks from now, I think it was like two or three weeks ago, ExxonMobil was trading at higher multiples than NVIDIA in terms of forward PEs.

44:06Now, that's reversed itself over the last couple of weeks as the markets have done quite well. And energy has retraced a lot of their rally in the month of March. But if we're looking forward and if we have a view that growth is going to slow a little bit, we're in an environment right now, if you look at some of the composite leading indicators that we track, where growth is positive, but it's kind of slowing at the margin. It's decelerating. That's an environment where overall stock market returns are pretty much average, if you will. But what factors perform best in that environment, particularly on the deceleration, is growth and is quality, right?

44:50And if you think about those larger technology names, they have both, right? They're growth companies. They're growing at the fastest amongst all sectors of the market. And they've got high-quality balance sheets, right? They've got a really wide moat. And so do you really want to be betting against the largest companies generating massive cash flows with solid balance sheets and trading at a roughly 20 % valuation discount to where it was six months ago? Probably not. And in an environment where growth is slowing, people are going to pay up for growth because it is a scarce resource, if you will.

45:28And so if I had to choose between value and growth and close my eyes for the next 12 months, I would, without a lot of conviction, but I would tilt myself towards growth. Yeah, I mean, right now, I think the number, if I'm not mistaken, the differential between the value side, the Russell 1000 value, the Russell 1000 growth, is somewhere about favoring this year to date, I think it was 6 % or 7 % in favor of value. Now, that spread was more like 11 % or 12 % for a few days there, which was unbelievable. And last year, value also did very well. These are the things that were really fascinating about last year.

46:05You got value, you got emerging markets leading into this year as well. Dollar coming down, more of a safety trade, more of the conservative model, more of the blue chips are considered the value side of things. Really kind of interesting stuff going on. But as we're talking about EM now, dollar did move down for a while. The safety trade came in, right? We saw the Swiss franc, the usual place. It used to be the yen too, by the way. The yen was always, but that's no longer. The yen is just disintegrating right before our eyes. And that's why everybody that I know, I'm like, you're going on vacation?

46:34Where are you going? Japan, Japan, Japan. Everybody's going to Japan. Are you going to Japan? I'm not. Yeah. We should go. We should go. But everybody's going to Japan. Seriously, like everybody's going to Japan. And understandably, because the yen is what, at 160, 159 or so. And what's really fascinating about all this is that really benefited emerging markets. Emerging markets were for years really not doing well. And once, though, the dollar turned around during this war, let's call it March, emerging markets got obliterated. Just obliterated because they thought that, number one, South Korea is in there and South Korea has, let me calculate, zero oil reserves.

47:20and they needed everything they can because they get their stuff from Iran or through the Straits of Hormuz and everybody's like, how are we going to do this? So long story short, do we still have a plan to invest and a desire to invest in EM? I would say in short, yes. Going into March, right, so at the start of the hostilities in the Middle East, we were in favor of emerging markets. We were also in favor of Japan. But in emerging markets, they show best on earnings and economic growth. Earnings revision, which can be a powerful factor, earnings revisions in emerging markets have been better than even the U.S.

48:03and the rest of the world. They have more fiscal and monetary policy flexibility than developed markets, which might be important tools as we look out through the rest of this year. They're improving their corporate governance, which is marginal, but it's a positive. and the weakening confidence in the US dollar is also a tailwind. And so there was a lot that was going for emerging markets and looking out 6, 12, 24 months, very positive on that. The war in Iran has absolutely dented the trade, but we don't think it's completely disintegrated it. To your point, EMs, Japan as well, but those are asset classes that are pretty large oil importers and specifically oil importers from the Middle East and Asia, which is a large portion of the emerging markets index, specifically so.

48:58So they've naturally been hit hard in the recent turbulence. They've also rallied the most off of the bottom, right? And so - That was incredible. That was a big rally. The COSPI in Korea is up 20 % month to date. And we're only in the middle of April right now. and emerging markets are up roughly 12%. Both are obviously better than the rest of the world. And so ultimately how things play out will depend upon the conflict and the duration and the intensity and all those kinds of things. But sitting here today, we're still positive on emerging markets. And one of the things that we've done with so much uncertainty around us, when you're uncertain about things, you should have less confidence in things.

49:42When you have less confidence in things, You should take less risk. And we've been bringing a lot of our kind of active positions closer to neutral, if you will. And we've done the same with emerging markets. So it's interesting because I like that. That's something you've mentioned twice now. And I think it would be really helpful for people that are listening to understand more about what does that mean when you say things like, you know, we're going to neutral. You know, we're going to overweight. Now, by the very nature of a fund group that tracks an index, you can't get too far away from the center line.

50:22Is that a true statement? Yeah, yeah. So in overweight, if we're overweighting, I don't know, pick something. If the weight of a particular benchmark that you are looking at but that you want to massage around and it's actively traded, It could be your own benchmark. It doesn't matter what the benchmark is. Is let's say, you know, 10 % emerging markets is an overweight. It's not 20%, right? It's more like 12 to 15, maybe? Yeah, it depends on the portfolio, right? And it depends on the flexibility that we've been given. But for the most part, excuse me, if you think about like a portfolio with a moderate amount of risk, Generally, that's the quintessential 60-40 portfolio, 60 % equities, 40 % fixed income.

51:12And for portfolios that we manage that are intended to be stable, predictable, long-term investments, we can be plus or minus 10 % equities versus fixed income. And it's not often that we - That means 70, 60, it can be 70 or 40, or does it mean 10 % differential from the 60? From the 60. So equities can be anywhere from 70. Right, yeah, okay. Yeah, with neutral. And bonds can be anywhere from 30 to 50. And then within asset classes, so let's just think regionally in equities, you know, plus or minus 10 % similarly is about right. And so one of the things that you don't necessarily want to do is have a high conviction view and be wrong, right?

52:05And so we will be, for the most part, plus or minus five on emerging markets. And that's a riskier asset class, a riskier region than the rest of the world. And so you want to calibrate things based upon how much risk they contribute to the portfolio overall. and those assets that are a little bit more stable, you can afford to have a little bit more leeway around that without getting too far out over your skis in terms of risk. But generally, kind of plus or minus 10 % on the cross asset. So equities versus bonds versus cash, for example. And then plus or minus 10, as a general rule of thumb, U.S.

52:48versus international versus emerging. I'm talking very obviously fine level. So what about, you mentioned the word predictable. What part of the process matters most when markets are unpredictable? You have a whole big process, I know. But what is it that when markets become unpredictable, what is it that you do that matters the most to make sure that you stay where you want the portfolio to be? Does that make sense? Humility? Yeah. Maybe it's humility. Right. Yeah. There are times when you want to be on your front foot and you you kind of want to be pressing on the gas pedal. There are times that you want to have your foot firmly on the brakes.

53:33But there's also times kind of like now where you don't need to be a hero and kind of perhaps pull over and wait for the turbulence without a ton of, you know, without taking a ton of directional risk. And when things are unpredictable, like I said, it's there's not a perfect playbook for anything, but a playbook for geopolitical tensions is one that is really, really difficult to to game plan for. And so I just laugh because especially with geopolitics, it played out on Twitter. Yes. And I don't know what the next social media post is going to be. Yeah. People who do and have a lot of confidence in that are probably not telling the truth.

54:16Yeah. And and so when when risks go higher, when correlations go higher and when uncertainty is high, you know, those those are one of those times that you just don't want to take a lot of active risk relative to, you know, whether your benchmark is not losing money or it's some sort of a market based benchmark. and kind of wait the play out and wait for the fog to kind of lift. So is that, when you talk about risk in this headline-driven, choppy environment and all that, is that kind of good risk management? Is kind of adjusting at the edges right now, looking at, I'm putting words in your mouth here because I think we've talked about this, but look at now, But always have the forward view also squarely in focus so that you don't miss that opportunity and do something stupid because of a near term situation.

55:18Yeah, yeah. And, you know, in uncertain environments like now, it's not a great time to take undue risks. It's not a great time to try to be a hero, right? Particularly when it's really difficult to have any sort of edge on things. And getting it wrong loses credibility and there's career risks in that. And that's important because that's the point, right? The career risk is important to look at. I mean, look, we could say, well, that's selfish of the portfolio manager. But the fact is that if you're investing in a particular portfolio and you want to do a certain thing and your manager goes off the reservation in a bad time, that's just, yeah, there are some funds that you invest in or ETF or whatever it is, some actively traded environment that that's what they do.

56:19Right. And you can't be upset about that. But I think that that is one of the ways that you hold your manager accountable for style drift issues. That's the point, right? Yeah, you got to be true to your style and you're more easily forgiven for not making enough when things are going well than you are for losing a lot of money when things are going poorly. Yeah. Let's just finish up on this. I want to talk about target dated funds and target allocations. First of all, I find it fascinating that most 401ks, you do a lot of 401k business, I know you guys do. And target date funds are a big part of that because people that can't decide, they basically get an actively managed portfolio packaged that should be theoretically appropriate either for a risk or age-based process.

57:16The target date, first of all, have you been hearing anything at all about the potential to put ETFs inside of 401k plans? ETFs or? ETFs. Alts. Forget about alts and all that stuff. You know, the whole crypto community was trying to get in there. And thank God we had a little bit of a blow up where private credit, private equity is probably never going to get in there now. So I'm actually morbidly thrilled about this happening for the benefit of the average 401k participant, to be honest with you. But let's talk about – that's my opinion. You may differ. But ETFs, are they coming – are they going to get in there?

57:55Yeah, yeah. And so target date funds can come into a couple of different types of wrappers. And we have some that are managed in different – without getting into too much details – into different types of wrappers. But what you find under the hood, whether it's a mutual fund or a collective investment trust or a separately managed account, can be mutual funds. It could be ETFs. It could be individual securities. But what is probably most common are underlying mutual funds. ETFs are getting utilized a lot more, partly because you can get, in the case of passive, you can get market exposure at a very low price, right?

58:40And so every basis point that you're paying is a basis point that's not going to your returns that you're saving for retirement. So it's not necessarily a race to a bottom, but cost really matters in that target date space. Have there been any change? I saw one big change a number of years ago. For a long time, target-based funds. And by the way, target-based funds for descriptive, for those of you that are listening that are like, what is this guy talking about? Essentially, it's something like this. If we have a target date fund, if you're 30 years old and you look at your retirement at age 65 just as a number, that's 35 years from now.

59:19What happens is that that would be a, quote, unquote, 35-year portfolio until you retire, starting off with maybe a high amount of equities, rotating ever so gently throughout the years to a point where you get very little risk by the time you retire. Just from a very easy-looking standpoint. That's how it was in the beginning. It was easy to understand. What happens is that you would stay in that. You did not have to move because as you got closer and closer to retirement, it would just do its thing naturally. There was an advent of a risk-based target allocation fund that would change based on not only age but risk factors.

1:00:02It's kind of a multifaceted way of constructing the portfolio, right? Is there anything else new on the horizon for this at all?

1:00:16Most likely not. What we've seen, and we've had outside of the US and in some other countries, we've had target date funds that have three separate and distinct, or had, we no longer have them, three separate and distinct levels of risk tolerance. And the idea there is that you and I could be roughly the same age, and therefore our high-level kind of profiles would have a very similar level of risk tolerance. But we could have different situations from a financial perspective. We could also have a different attitude towards risk. And the examples that I would use, I could see my wife in a casino with her friends, and they would do very different things.

1:01:10And some would be very conservative, some would be much more aggressive. And it gives people an extra layer of flexibility for those who want to take on more risk, who are comfortable taking on a little bit more risk or less risk to opt for the more aggressive glide path or the aggressive fund, if you will, or the more conservative. What we have found is that most people will default to what's in the middle. And so the asset gathering in the more conservative and the more aggressive ones was not anywhere near that of the moderate funds. And so generally what we found and what we ultimately did, this is a couple of years ago, is just defaulted everybody back to the moderate fund.

1:01:58That makes sense. And play a little bit further up or down that glide path if you want to take on a little bit more or a little bit less risk. I hear you. Tom Nelson, thanks for joining us. I really appreciate it. Tom Nelson, Franklin Templeton Funds. Make sure to check out all the things they have to offer. And I appreciate all the wisdom that you've provided us today. Thanks. It was great. Thank you, Andrew. Thanks. A lot of information there, a lot of discussion about all sorts of things from macro environment, from economic indicators to consumer confidence in the AI trade. Tom Nelson was great.

1:02:29Thank you so much for that. Another great discussion with another great guest that we had this week. And, of course, rolling down into the end of April, we have more great guests coming up. We have a whole host of great people. Wes Gray's coming up in the next couple of weeks. Plus, plus, plus. It's going to be good. Make sure to keep your dial pointed to the Disciplined Investor Podcast on Apple Podcasts, Spotify, YouTube. Amazon. It's all over the place. Make sure to stay tuned and be here next week as well. I look forward to seeing you then. Thanks.

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