Radio Show - Decade End Returns and Valuations…Process vs. Performance…VC Power Laws | #200

Episode Summary

Executive Summary: Meb Faber and Justin Bosch discuss the importance of perspective in investing, using the COVID-19 outbreak as a case study for how external shocks should minimally impact long-term investment strategies. They analyze decade-end market returns, highlighting the dangers of extrapolating recent performance, the value of valuation-based investing (like CAPE ratios), and the disconnect between stated processes and actual performance-chasing behavior. The conversation covers the power-law dynamics in both venture capital and public markets, the biases in portfolio construction (e.g., constraining trend-following weights despite optimization), and the hidden risks in index funds with mechanical rules that can lead to extreme concentration. They also touch on emerging opportunities in frontier markets like Africa and the nature of high-Sharpe strategies like option selling.

Main Topics: Perspective on External Shocks (Priority: 5/5): Using the COVID-19 outbreak as an example, the speakers emphasize that external shocks (like viruses, elections, or geopolitical events) rarely justify altering long-term investment strategies. They highlight the contrast between media-driven fear and historical evidence of market resilience, noting that the flu kills significantly more people annually than COVID-19, yet investors rarely panic over it. Decade-End Market Returns and Valuation Distortions (Priority: 5/5): Analysis of 2009-2019 returns shows US stocks returned 13.6% annually, but were actually the worst performer among four major asset classes over the prior 20 years. Speakers discuss CAPE ratio dispersion across countries (e.g., Belgium from 8 to 24, China cut in half), illustrating how extrapolating recent decades is a common investor mistake. Process vs. Performance: The Bias in Manager Selection (Priority: 4/5): Institutions claim to evaluate managers by process, but in practice often fire them for underperformance—exactly when they should be buying. The lack of clear sell criteria leads to buying high and selling low. The speakers advocate for documenting sell rules at purchase and allocating more to poorly-performing asset classes with sound fundamentals. Power Laws in Venture Capital and Public Markets (Priority: 4/5): VC investing is dominated by power laws: a tiny fraction of investments drive the vast majority of returns (e.g., Jason Calacanis: 3 of 200 companies accounted for 98% of returns). In public markets, the 'coffee can portfolio' concept shows winners must be held for decades; illiquidity in private equity is paradoxically an advantage because it forces investors to stay invested. Hidden Dangers of Indexing and Mechanical Strategies (Priority: 4/5): Index funds are not all passive: mechanical rules (e.g., dividend aristocrats index) can lead to extreme ownership of single stocks (22% of outstanding shares in one case), creating large forced trades. The 'dirty secret' is that index methodology changes or rebalancing can impose 1-4% annual hidden costs. Active management of index rules is often necessary. Opportunities in Frontier Markets (Africa) (Priority: 3/5): Africa represents 14% of global population but only 1% of market cap, making it a demographic opportunity with low competition. Most investors ignore it, leading to potential inefficiencies. The speakers suggest thoughtful approaches like equal-weighting or value-tilting instead of market-cap weighting, which would concentrate in South Africa. High-Sharpe Strategies: Option Selling and Its Risks (Priority: 3/5): Option selling (e.g., strangles, straddles) can produce Sharpe ratios of 2.0-3.0 and consistent monthly returns, but carries catastrophic left-tail risk. The speakers describe a refined version that biases positions in the direction of the trend, but warn that most option-selling strategies eventually blow up.

Key Arguments: External shocks like COVID-19 should not drive portfolio changes; historical perspective shows markets have survived far worse (wars, pandemics, etc.) and the flu is a far greater annual risk (50,000 US deaths/year vs. ~500 from COVID-19). US stocks were the worst performing of four major asset classes (REITs, emerging markets, gold, US stocks) over the 20 years ending 2019, yet investors assume they are the best by extrapolating the recent 10-year bull run. CAPE ratios globally show massive dispersion over the past decade: some countries doubled (Belgium), some halved (China, Colombia), making valuations a critical but underused anchor for allocation decisions. The investment industry's process talk is often lip service: managers are fired primarily for performance, not process failure. Selling an asset class or strategy after prolonged underperformance is usually the worst time to leave. Index funds are not all passive—mechanical rules can cause unintended consequences like owning 22% of a single stock. The real cost of index churn can be 1-4% annually, hidden from investors. VC and angel investing succeed by forcing illiquidity; the 10-year lockup prevents the natural human tendency to sell winners too early. This can be replicated in public markets by setting long holding periods. Frontier markets like Africa offer demographic tailwinds (14% of population, 1% of market cap) and lack of competition, making them fertile ground for skilled allocators who can handle illiquidity and concentration. Option selling can generate high Sharpe ratios but is essentially 'picking up quarters in front of a steamroller'; sustainable strategies require tiny position sizing and maximum diversification to avoid blow-ups.

Data Points: Annual US Flu Deaths vs. COVID-19 Deaths (early 2020): 50,000 vs. ~500 - Providing perspective on the coronavirus panic relative to the flu. 2019 US Stock Market Forecast Range: -4% to +10% - All strategists' forecasts fell within this narrow range, but actual returns are outside this range in 4 out of 5 years. US Decade Return (2009-2019): 13.6% annually - US stocks were the standout performer in the last decade but the worst performer over the prior 20 years. Ireland CAPE Multiplier (2009 to 2019): 10x increase - From near-collapse to massive expansion, showing extreme valuation swings. China CAPE Ratio Change (2009 to 2019): Halved - From 29 to lower single digits/teens, despite continued growth, making it relatively cheap. Trend-Following Optimal Allocation (Goldman Study): 50-89% - Optimization suggested huge trend-following weighting, but institutions constrain it to ~5% due to career risk. Africa: Population vs. GDP vs. Market Cap: 14% pop, 5% GDP, 1% market cap - Illustrating the disconnect and potential opportunity if convergence occurs. VC Return Concentration (Jason Calacanis): 3 of 200 companies = 98% of returns - Exemplifies the power-law distribution in venture capital. Option Selling Sharpe Ratio: 2.0-3.0 - Theoretically achievable, but with high risk of catastrophic loss (left-tail event). Dividend Aristocrat ETF Ownership of Single Stock: 22% - Mechanical index rules caused extreme concentration; forced selling during rebalance created large market impact.

Pivotal Quotes: "If you are an evidence-based investor, is that because trend following is so uncorrelated to a traditional portfolio... it almost always spits out an enormous number that you should be allocating to trend following. But how many investors and allocators... allocate a huge portion of trend following? Well, almost none." — Meb Faber: Highlighting the gap between quantitative optimization and real-world portfolio construction constraints driven by comfort and career risk. "The challenge is that latter part of being able to hold the winners, and this goes back to the power laws of investing, where you own an index, it's guaranteed to own the big winners. But if you do it where you're buying individual names, the challenge is selling those winners as they become the 5, 10, 50, 100, 1,000 baggers. Private equity has a hack that does it by you can't sell it because private equity VC managers you have to hold for the life of the fund, which is traditionally 10 years." — Meb Faber: Explaining why illiquidity can be a feature, not a bug, in investing because it prevents premature selling of winners. "The old Chris Meyer book... most of these take 10 years plus, you know, the fastest that anyone's ever done a hundred-bagger I think it might have been like Monster Beverage, which did it in like four years. But that's still a pretty long time for most people." — Meb Faber: Emphasizing that even 'fast' multi-hundred baggers require multi-year holding periods, well beyond typical investor patience.

Implications: Investors should embrace humility, set long-term rules (including sell criteria), avoid performance-chasing, and consider illiquid or out-of-favor assets (e.g., frontier markets, trend-following). Indexing is not passive—know what you own and the hidden costs of mechanical rebalancing. High-Sharpe strategies like option selling are dangerous long-term.