#107 - James Montier - “There Really Is A Serious Challenge to Try to Put Together an Investment Portfolio That’s Going to Generate Half-Decent Returns On A Forward-Looking Basis"

60 minutes

In Episode 107 we welcome the great James Montier. The chat starts on the topic of James’ questionable sartorial choices. He tells us he’s “always been a fan of dressing badly.” But the guys quickly jump in with Meb noting how James has generally been seeing the world as expensive over the last few years. Has anything changed today?

James tells us no; by in large, we’re still trapped in this world where, frankly, you’re reduced to this game of “picking the tallest dwarf.” In general, every asset is expensive compared to normal. He summarizes, telling us “there really is a serious challenge to try to put together an investment portfolio that’s going to generate half-decent returns on a forward-looking basis.”

Meb digs into, focusing on James’ framework for thinking about valuation, specifically, as a process.

James starts from accounting identities. There are essentially four ways you get paid for owning an equity: a change in valuation, a change in profitability, some growth, and some yield.  James fleshes out the details for us, discussing time-horizons of these identities. One of the takeaways is that we’re looking at pretty miserable returns for U.S. equities.

James notes that we now have the second highest CAPE reading ever. Or you could look at the median price of the average stock – the price-to-sales ratio has never been higher. Overall, the point is to look at many valuation metrics and triangulate, so to speak. When you do, they’re all pretty much saying the same thing. James finishes by telling us that from his perspective, U.S. equities appear obscenely expensive. 

Meb takes the counter position, asking if there’s any good argument for this elevated market. Is there any explanation that would justify the high values and continued investment?

James spends much time performing this exact exercise, looking for holes. He tells us that most people point toward “low interest rates” as a reason why this valuation is justified. But James takes issue with this. From a dividend discount model perspective, James doesn’t think the discount rate and the growth rate are independent. He suggests growth will be lower along with lower rates. He goes on to discuss various permutations of PE and other models, noting that there’s no historical relationship between the Shiller PE and interest rates.

Meb comments how so many famous investors echo “low rates allow valuations to be high.” But this wasn’t the case in Japan. Meb then steers the conversation toward advisors who agree that U.S. stocks are expensive yet remain invested. Why?

What follows is a great discussion about what James calls the “Cynical Bubble.” People know they shouldn’t be investing because U.S. stocks are expensive, but investors feel they must invest. If you believe you can stay in this market and sell out before it turns, you’re playing the greater fool game. James tells us about a game involving expectations – it’s a fun part of the show you’ll want to listen to, with the takeaway being how hard it is to be one step ahead of everyone else.

The conversation bounces around a bit before Meb steers it toward how we respond to this challenging market. What’s the answer?

James tells us there are really four options, yet not all have equal merit:

1) Concentrate. In essence, you own the market about which you’re most optimistic. For him, that would be emerging market value stocks. Of course, buying and holding here will be hard to do.

2) Use leverage. Just lever up the portfolio to reach your target return. The problem here is this is incompatible with a valuation-based approach. Using leverage implies you know something about the path that the asset will take back to fair value – yet it may not go that route. You may end up needing very deep pockets – perhaps deeper than you have.

3) Seek alternatives like private equity and private debt. The problem here is most are not genuinely alternative. They’re not uncorrelated sources of return. James tell us that alternatives are actually just different ways of owning standard risk.

4) The last option is James’ preferred choice. Quoting Winnie the Pooh: “Never underestimate the power of doing nothing.”

Next, Meb brings up “process” as James has written much about it. James tells us that process is key. Professional athletes don’t focus on winning – they focus on process, which is the only thing they can control. This is a great part of the interview which delves into process details, behavioral biases, how to challenge your own views, and far more. James concludes saying “Process is vitally important because it’s the one thing an investor can control, and really help them admit that their own worst enemy might be themselves.”

There’s plenty more in this great episode: James’s answer to whether we’re in a bubble, and if so, what type… market myths that people get wrong involving government debt… and of course, James’ most memorable trade. This one was a loser that got halved…then halved again…then again…then again…

How did James get it so wrong? Find out in Episode 107.

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