Eduardo Repetto, CIO of Avantis Investors, discusses a variety of concepts related investing for higher expected returns.
Listen now and learn:
- Why different securities have different expected returns
- The shortfalls of style indices
- A theoretical framework for value investing
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Show Notes
I’m joined by Eduardo Repetto, chief investment officer of Avantis Investors. Eduardo is responsible for overseeing the research, design, and implementation of the firm’s investment strategies.
Prior to forming Avantis in 2019, Eduardo was co-CEO, co-CIO, and a director at Dimensional Fund Advisors. Eduardo earned a Ph.D. in aeronautics from the California Institute of Technology, and an MSc degree in engineering from Brown University.
In just under three years since launching their first funds, Avantis already manages over $12 billion in assets, which is incredible growth for a new asset management company. Our conversation digs into the underlying philosophy that drives many of the strategies at Avantis.
Here are my notes from the conversation.
3:00 – What is a Factor?
Stocks move in different directions – some go up in price, some go down in price – but there are some groups of stocks that tend to move together more than others. Securities with certain characteristics that tend to move together are said to have co-movement.
Factors are used in finance to identify securities that move together. For example, small-cap stocks tend to move together as do companies with a very low price relative to fundamentals (earnings, cash flow, book value, etc).
A factor is a way to define what securities have this property of moving together. There are many different factors, but some are more important than others. Some factors are associated with higher expected returns. Others are important for diversification purposes.
When you’re thinking about diversification, for example, you might start by saying you will own a lot of stocks, which is good unless all the stocks you buy have similar characteristics and they move together. In essence, you have different eggs, but they’re all in the same basket – they move together.
6:30 – Why Do Some Factors Have Higher Expected Returns?
Different securities have different expected returns. The underlying reason for this is that every security has different characteristics.
If you buy the total U.S. stock market, there is no reason to expect every stock to have the same expected return – some securities have higher expected returns and some have lower expected returns. And if the price of a security changes, the expected return of that security also changes.
The expected return of any given stock isn’t constant. It’s a dynamic process because the price changes and the fundamentals (earnings, liabilities, etc) change.
When the fundamentals change, the price also changes – and depending on that relationship between fundamentals and price (how much one changes versus the other) the expected return of that security would go up or down.
Think about a company making earnings (a stream of cash flows) over time – the more you pay for the earnings, the higher the price of a security and, in turn, the lower your expected returns because you’re paying more money for those cash flows and future earnings. The lower the price, the higher expected returns because you’re paying a lower price for those cash flows in the future.
How can you identify what securities have higher and lower expected returns?
If you want to create a portfolio that performs better than the S&P 500 or the total U.S. stock market, what matters are the fundamentals (earnings, balance sheet, etc.) and the price.
For fundamentals, you want to know how much a company makes, but the balance sheet matters too. A company might make a lot of money, but be full of liabilities. You also might have a company with high revenue, but not earnings or future earnings.
The other thing that matters is price. Because if you pay too much for something, returns will probably be low. If you pay a low price for something, returns will probably be high.
Imagine someone is telling you about an amazing restaurant with great food and great services. Is that a good restaurant for you? Well, it depends on the price. You may enjoy the food, but if the price is exorbitantly high, that’s not good for you. If the price is low and the food is great, then you’ll want to go right away. Price matters. But it’s not just price – it’s price relative to the fundamentals.
10:40 – What Is Value Investing in the Context of Factor Investing?
The definition of value, like many things in investing, has evolved. That’s reasonable because science of all knowledge will evolve and data availability evolves, so it’s good to embrace this evolution of knowledge.
At the simplest level, value investing is about paying a low enough price relative to whatever fundamentals you are thinking about that it seems to be a good deal. And if it’s a good deal, that means you have higher expected returns than the market.
In other words, you are buying something that is such a good value to you that you buy it instead of buying the market.
Going back to the restaurant example, a 3-Star Michelin restaurant with a low price is great. Especially if we are comparing it to a restaurant with no stars and the same price. If the price is the same, but the 3-star one has amazing food and amazing service, you will probably pick that one because it represents value to you.
But if the same no-star restaurant is one-tenth the price of the other one, you might decide the food is good enough for price you’re paying. That’s value for you.
Value is what you get relative to what you pay.
When we think about companies, we are buying a company’s future earnings. And we’re buying the balance sheet. You want to pay as little as possible for those future earnings and that balance sheet. That’s why you buy a company.
You want to buy a company that has good profitability and a good balance sheet at a low price. Depending on the relative value (the relative comparison between the price that you pay and these two fundamental variables), some companies are more attractive than others from the expected return point of view.
It’s the same as the restaurant example. If you tell me that a company has low earnings, but the price is extremely low, that may be a better than a company with high earnings and a price that is a little bit high.
So it’s that relative comparison between the company fundamentals and the price that allows you to say which companies seem to have higher expected returns than other companies.
14:11 – The Importance of Diversification
We know information about any given company as of today. Take a company that is run well and the price is low. While everything with that company seems great, tomorrow there may be new information that is negative such as the CEO takes off or a new competitor comes to market with better technology – there is a lot of uncertainty around all of this.
The moment you have uncertainty, it’s not a sure bet anymore, so you want to diversify that uncertainty risk. By having another company that also has a low price (so also high expected return), you are more diversified and have less uncertainty by having them both because it is unlikely that both would have the same bad news come in at the same time – maybe one or the other (and in most cases, probably neither).
But the more that you have of these companies, the more that you diversify that uncertainty about, for example, future bad news.
It’s not that you’re sacrificing expected returns because you’re finding a group of companies at a low price relative to some set of fundamentals, but you’re minimizing risk by minimizing the uncertainty about future outcomes that are not known today.
If we go back 80 or 90 years, these concepts were not completely understood. People were thinking with respect to returns, but not completely thinking about the tradeoff between expected returns and diversification and risk management. But it’s understood today that diversification is like a free lunch, you’re not giving up much for the benefits of reducing the risk of uncertain or bad outcomes.
18:08 – Expected Returns
Let’s go back to our restaurants. Let’s suppose you have three restaurants.
- The first has amazing food, and the price is $10, but the drinks are really bad.
- The second is $10 with amazing drinks, but the food is horrible.
- The third has great food and great drinks, and it’s also $10.
Which one is a better value for you? The one with great food and bad drinks, the one with great drinks and bad food, or the one with great food and drinks at the same price?
If you’re going to eat, you’re going to need to drink something (at least water). If you’re going to eat, the food ought to be good no matter how good the drinks are because otherwise, you would just go to a bar.
Maybe the first two restaurants are a good deal because the price is good, but it’s not really an amazing deal. But if you compare them to a restaurant with great food and drinks for the same price, that’s even better.
Now let’s talk about companies. Suppose there is one company with a good balance sheet, but the earnings are really bad. Then there’s a second company with great earnings, but the balance sheet is horrible. Then there is a third company with a good balance sheet and good earnings. All three companies have the same price.
The best value is the one with the good balance sheet and earnings for the same prices as the other two. This is what you see in the data.
Looking at the expected return of companies and everything related to price, you want companies that have these two characteristics together. You’re looking at these two characteristics together along with their price. Good cash flows, reasonable balance sheet, also trading at a low price. Those securities have very high expected returns when you compare it with the rest of the securities in the market.
Those are the types of companies you want to own in excess of market weight, if you want to have higher expected returns – this is what Avantis value strategies do. They try to focus on those companies.
Thinking about it in a more technical manner, there are companies with high discount rates –for whatever reason, the market is pricing them at a low price. If there is a company with great earnings, you would generally expect the price of the company’s stock to be high. But when you look at the price and see that the price is low, then that might be a good deal – the price happens to be low despite the fundamentals, so it has a higher expected return.
21:18 – The Problem with Style Indexes
The Avantis website says they are built around one investment philosophy: “We believe market prices represent an unbiased view of a company’s prospects and risks, and that paying lower prices for our share of future cash flows should produce higher expected returns.”
That almost perfectly summarizes what Eduardo has been talking about. There’s also a clear signal of belief in the efficient market hypothesis (EMH), which is the idea that market prices incorporate all known information to the extent that predicting the future and consistently profiting from any potential mispricing is impossible.
One of the mistakes I used to make earlier in my career was that the case for being an index investor was the efficient market hypothesis. But in reality, the original case for indexing is that everyone in the market is trading with each other, so everyone earns the market return minus their costs and indexing gives you the cheapest cost.
With factor investing, it takes advantage of the efficient market hypothesis in the sense that price incorporates all known information.
When I make reference to indexing, Eduardo is quick to point out a shortfall of indexing that is less of a problem when using a total market index, but relevant the moment you deviate from the market portfolio.
When you do anything other than use a total market index, you’re making an active decision to be different, even if you are using an index fund. Whether you are buying a small cap index, a value index, a growth index, etc – someone is defining the rules for that index and those rules are very rigid.
For example, we were speaking about the price of the restaurant being low relative to its three-star status (it has great food and great drinks). So today we go to this restaurant that has great food and drinks for a great price – that’s a good decision.
Now let’s assume that today we are going to decide that we will go there every Friday night for the next year. But the restaurant can change their prices. Imagine they decide to multiple their prices by ten. Then you might start questioning whether you should go to that restaurant every Friday. If you have the flexibility to stop going to that restaurant every week, you probably won’t.
The problem with a value index or small cap index – they tend to make decisions once or twice a year. So even if the index providers make the right decision about what securities to include once or twice a year, that decision isn’t necessarily correct once prices change in the months that follow.
The other issue with using a value index or small cap index is that when they decide a security no longer belongs in the index, they have to dump it right away in order to put new securities in the index that fit their rigid rules. Eduardo uses the word “dump” very intentionally because they must get that trade done no matter what, which comes with a lot of cost.
So style/fundamental indexes – and again, this is not as applicable when using a total market index – tend to hold securities they shouldn’t and they don’t consider changes in price.
Another example Eduardo gives is deciding what to wear the entire year based on today’s weather. When we recorded the episode, it was 98 degrees and very humid in St. Louis. What I would choose to wear based on the current weather is a bad idea because in January St. Louis will be freezing (we truly experience all the seasons here).
This is what an index is does and it makes no sense if your objective is to own a specific portion of the market such as value stocks or small cap stocks (again, this critique doesn’t really apply to total market indexes though). These indexes choose what to own once or twice a year, which makes there exposures imperfect once prices change. And once indexes reach the date that they re-evaluate the holdings and make changes, they dump securities that don’t fit the style without regard for the cost of those changes.
Eduardo’s distinction here is an important one. For all listeners and readers, you should know that whenever I’m talking about indexing, I’m referring to buying total market indexes. But the case for buying anything other than a total market index is flawed in the ways Eduardo explains.
28:59 – Total Market Index vs Factor Investing
If someone wants to hold the market portfolio, it’s hard to say anything bad about that decision.
Especially when compared to all the bad portfolios we see people have, the market portfolio is a very good option relative to a bad portfolio.
Even though buying a total market index isn’t necessarily bad, a factor-based portfolio seeks to improve upon it by deviating from the market towards areas with higher expected returns while maintaining a similar risk profile.
31:06 – Theoretical Framework and Empirical Evidence for Value Investing
We always see the disclosure “Past performance is not an indicator of future returns.” But a lot of the empirical research supporting factor investing is based on past performance.
Eduardo points out that one of the issues with empirical research is that something may happen in isolation in the past – whether that’s a once in a lifetime event or something that happens for many years – but there is no reason for it to continue in the future.
He points out that there are things in the past that don’t exist anymore. For example, think about payphones that you put a coin in. You could observe its existence in data for 80 years, but you wouldn’t want to expect those to coin-based payphones to exist for the next 80 years (they are nearly obsolete now).
He jokes that empirical research is like taking a child to the zoo and saying, “Look the animal with stripes is a zebra,” and then the child goes home thinking every animal with stripes is a zebra.
The data on its own is not enough – you need to have a theoretical framework for why what’s in the data should continue in the future.
The theoretical framework for Eduardo is all about valuations, or the price relative to fundamentals. If the company is trading at a low price relative to fundamentals, the company is probably faced with a big discount rate.
Imagine you are buying a business that produces cash flows and profits, the lower the price that you pay, the higher the discount rate you are using to discount those future cash flows, and the higher the expected return that you have from purchasing that business.
Alternatively, the higher the price, the lower you are discounting cash flows, the lower the return, and the less attractive the investment will be.
With the theoretical asset valuation framework in place, you can now look at the empirical data to see if it corroborates with the expectations from the valuation theory.
When you are looking at empirical data, you want to see the theory corroborate when looking at different security types, time periods, geographies etc.
36:00 – The Importance of a Long-Term Investing Mindset
Over short time periods, you will experience a humongous amount of noise. If you can’t really deal with that noise, you have to think about how you’re going to invest because investing is dealing with a lot of uncertainty and noise, and focusing on the long term.
Rather than focus on the short term and performance, you should spend more time trying to understand the investment process being used – both why it is being used and how it should be expected to work.
There will be market downturns regardless of your investment approach. History is full of downturns. Despite all of them, the market has delivered great growth for investors that are willing to deal with downturns. You just have to learn to be patient when dealing with uncertainty.
Additional Disclosures from Avantis Investors:
Expected Return: Our philosophy is based on the idea that paying less for an expected stream of cash flows or the equity of a company should produce higher expected returns. Our systematic, repeatable and cost-efficient process uniquely designed for Avantis Investors is actively implemented to deliver diversified portfolios expected to harness those higher expected returns.
Diversification does not assure a profit, nor does it protect against loss of principal.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Avantis Investors and Long-Term Investor Peter Lazaroff are not affiliated companies.
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