Portfolio Management: The Nuts and Bolts of Stock Diversification – Episode #426


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If you took a scientific approach and invested logically, would you know what long-term returns you might expect? That’s exactly what academicians attempt to do. On this episode of the Dentist Money Show™, Ryan, Matt, and Rabih discuss the variables academicians evaluate to better understand stock valuations. It’s a technical look at the time-tested principles used for systematic investing.

 

 

 

 


Podcast Transcript

Ryan Isaac:
Hello, everybody. Welcome back to another episode of The Dentist Money Show, brought to you by Dentist Advisors, a no-commission, fee-only fiduciary, comprehensive financial advisor just for dentists. Check us out @dentistadvisors.com. Today on the show is actually a special recording of a webinar, which you can find all of these archived at dentistadvisors.com with Matt and myself and fan favorite Rabih, CFA portfolio guy at Dentist Advisors in charge of all things investments. And today we’re talking about all the different reasons that stocks are not alike. Stocks are very different and the way that you put them in a portfolio in certain concentrations and how they interact with each other will give you a different experience in your investments from things like risk and volatility and returns.

Ryan Isaac:
And so understanding the basics and the key components of what makes stocks different can make you a better investor and help you build a better portfolio. That was our wish during this webinar. So thanks to Matt and Rabih for doing this, especially Rabih, all this content. You guys are so smart. I love having them on. If you have any questions for us or you wanna talk about your portfolio, go to dentistadvisors.com. Click the book free consultation button. Let’s have a chat with you. Thanks for being here. Enjoy the show.

Announcer:
Consult an advisor or conduct your own due diligence when making financial decisions. General principles discussed during this program do not constitute personal advice. This program is furnished by Dentist Advisors, a registered investment advisor. This is Dentist Money. Now, here’s your host, Ryan Isaac.

Ryan Isaac:
Tonight, we’re getting a little bit specific in the weeds. Matt and I are at an investment conference this week in California for a company called Dimensional Fund Advisors. And they kinda have a reputation. They’re a mutual fund company but they have a long, long storied reputation of being heavily research- and education- and data- and science-driven. So they become a pretty excellent resource to the advisor community to provide education around the science of investing and the data of investing rather than the emotion of investing or the trends of investing. So we’re gonna share some of the things that come from some of their education and just a lot of the academia and science around building a good investment portfolio. And the topic tonight is, why stocks aren’t all built the same. There’s no such thing as just a stock and they’re all the same. There’s many, many different kinds of stocks with different characteristics and qualities, and how you approach building a portfolio with them will impact your experience: The risk you take, the ride you have along the way, the returns you get. So that’s what the topic is tonight. Rabih, take it away, man. We’ll, dive right in.

Rabih Dimachki:
Sounds good. So I thought of starting this conversation with more of like a story so we understand the many sides of stocks. And usually we have conversations at work about this, but now I have a different format. I’m gonna be delivering it in a different way. So let me know whether you like it or not. So let’s start…

Ryan Isaac:
Oh, and that’s great. Sorry, Rabih. Yeah. Yes. And because you are now a newly minted surfer, I have actually like an ocean analogy I wanna bring up too in the beginning here…

Rabih Dimachki:
Perfect. [chuckle]

Ryan Isaac:
That I think you’re gonna love and it is gonna be helpful. I hope so. Yes. I’ll follow up from…

Rabih Dimachki:
Drop it in whenever you feel it’s convenient.

Ryan Isaac:
I’ll follow you… All right.

Rabih Dimachki:
Okay. So I’m gonna start by giving you all background. So where we have the same starting point, and I promise, although it’s gonna get technical, it’s gonna be very informative and rewarding at the end. So let’s start with something called the capital asset pricing model. I’m not here to bore you, but this is a good starting point for us to understand what factors are, why are they a hype in the investment management industry, why now we hear of strategies like smart beta and tilts in a portfolio. If we want to start from the capital asset pricing model, we’ll have like a easy journey going forward. So the capital asset pricing model is simply what the academics described in formulas as something that came out of diversification.

Rabih Dimachki:
We all know that you should diversify your portfolio. You should diversify from individual stock positions so your portfolio is more robust. And the capital asset pricing model simply said, if you buy a company that is more sensitive to the market or riskier than the market, it should be very similar to just buying the index, buying the market and leveraging up. Or if you buy a company that is more stable than the economy and doesn’t fluctuate as much, it is gonna be equivalent to just buying the market but not putting all your money in it, diversifying it with cash. So [chuckle] logically, you can never outperform the market if you buy an individual stock. And I know that this is not gonna sound correct because this is not the reality of things. If you buy Nvidia this year, you would’ve done much better than the market. And if you bought Disney this year, you would’ve done much worse than the market.

Rabih Dimachki:
So there’s a graph on the right-hand side where it just shows a straight line going upwards. And that is what the market performance should be and how the risk fluctuates. And the logic behind this model is that given a stock will not outperform the market, it’s just gonna be riskier or less risky and you just adjust the risk. The logic behind it is that all stocks should fall on this line, which what you see as Xs on this line extending from left to right upwards. So this was the logic, and just said equity returns are proportional to their exposure to market risk. But in reality it’s not like that. And in reality, those Xs, those individual stocks are really different than what the market.

Rabih Dimachki:
So just thinking of dividing the risk of a stock by the market is not gonna guarantee and explain the returns you are getting. This means when you invest in Nvidia this year, there is another facet to this risk other than the market risk that you are seeing, which explains why Nvidia outperformed. And if you invested in Disney this year, there’s another facet, there’s another side to the stock story other than the market return, the sensitivity to the market that explains why Disney underperformed. So to generalize and continue with the story, the reason people figured out that the capital asset pricing model doesn’t work was because of people like Warren Buffett. Warren Buffett decided to buy value stocks and suddenly was outperforming the market.

Rabih Dimachki:
This really confused academics who were following this capital asset pricing model and thought that every stock should just be on that line and it shouldn’t be natural for Warren Buffet to outperform. Is this a market anomaly? What is going on to describe why some stocks outperform or underperform the market if you know it is adjusted for that risk? And here is where the term “factor” came into fruition. A factor is simply a different risk other than the market risk that we know of the academics created to try to explain why stocks might perform differently than the market when you adjust for that risk. Is that clear [chuckle] in any sense?

Ryan Isaac:
Yeah. I like that you started here very academically to this pricing model, this equation, this formula, this math here is just, it’s trying to explain why stocks behave the way they do. But I like that you said, here’s the math and then here’s the reality, the experienced reality of people who actually own stocks that end up all over the map, higher or lower returns for all kinds of different reasons. The story I was gonna share really fast, appropriate since we’re in California, Rabih is a new surfer, welcome to the club; a lot of people will, when they talk about ocean waves or surfing ocean waves, people will… The question will be like, are waves good? Are the waves good today? And what’s interesting about an ocean wave when you’re talking about surfing is, no waves are the same, and just explaining a wave by its size doesn’t tell you nearly the whole story.

Ryan Isaac:
What’s really fascinating about forecasting and experiencing a wave in the ocean is, wind is a factor. So you can have really great waves with really crappy wind and it makes the great waves turn crappy. Or you can have crappy waves with really good wind that makes the crappy waves turn good. You can have really small waves that feel really powerful. You can have really big waves that feel really weak. You can have waves on a high tide and a low tide. You can have waves that come in from the south, the west, or the north. All of these things shape the experience of how you’re gonna experience the wave itself. There is no such thing as just what is the wave gonna do? You have to bring in all of these other factors that shape the experience of how the wave’s gonna be in the ocean.

Ryan Isaac:
And I like that idea because stocks are not that simple either. It’s not just what do stocks do? Should I buy them? Should I not? Are they good? Are they bad? Did they go up? Did they go down? It’s, well, it depends. There’s a lot of different kinds and they behave differently under different conditions for different reasons. And that’s the whole point of tonight. So I like that you began here ’cause this is kind of like saying, what should waves do? And you’re like, well, technically waves come in, somehow the moon makes them form, they hit a shallow part of the coast and then you have a wave, but they change based on half a dozen other factors involved. And so that’s what we’re gonna talk about with stocks and how they change, why you end up getting Xs all over the map instead of landing on this perfectly straight experience the whole time. So.

Matt Mulcock:
Well, and to that point, Ryan, I think the other part of this too that I’m sure this will be a theme, Rabih, and sorry if I’m jumping ahead, but also just thinking about the idea that like the idea of randomness here as well, that needs to be highlighted, and the fact that certain stimulus or factors or like as you’re referencing the wave, Ryan, and depending on the situation when it comes to stocks, one factor in one period of time is gonna make that stock price or whatever react differently. Or the market’s gonna react differently to different stimulus in the market now versus five years from now or different 10 years ago. So that’s the other hard part about this as well, and this is why we talk about the fact that market timing is nearly impossible. Because you could have the same exact stimulus, the same exact kind of factor within the market from one year to another or decade to another, and have an exact opposite outcome in the markets themselves. So I think that’s really critical to understand as well is just it’s really, really hard to know from year to year, quarter to quarter, whatever, decade to decade how things are gonna react in the market.

Ryan Isaac:
Perfect. That’s great. Thanks, Matt. Thanks, Rabih.

Rabih Dimachki:
Exactly, exactly. And because there is so much noise, like in summary, they thought that you can explain what a stock will do by just looking at the market. And if it’s riskier then the market doesn’t do better than the market in days of upside. And if it’s less risky than the market, it won’t move as much. That was the intuition. The market proved them wrong, then the market isn’t the only thing that they should look at. And they developed factors. So what are they really? Spoiler alert: Given that they are made by academics, they are not really so fun. But I have an analogy on…

Ryan Isaac:
I think they are pants. [chuckle]

Rabih Dimachki:
They’re pants. They are pants. So I have…

Ryan Isaac:
So just so we’re like explaining things to everyone factors, we’re saying, what are the different variables that change the behavior of owning a certain stock? That’s what we… When we mean factors, what’s the wind like? What’s the tide doing? What’s the swell direction doing? These are all the different things that change how a stock’s gonna behave when we say factors. So pants.

Rabih Dimachki:
[chuckle] So pants. Actually I feel sad talking about pants because your ocean analogy is much like cooler than pants. [chuckle]

Ryan Isaac:
[laughter] Sorry, I like a good pair of pants like anyone else.

Rabih Dimachki:
But yeah, it is in line with what you were saying and the factors as an analogy are just like properties of the asset we’re looking at in a stock, it’s properties of a stock. In a wave, it’s like its properties of that wave. And in pants it’s the same. So the question was, which pants will make you win the award at a pants-only fashion show, right? If you’re only going for pants-only fashion show.

Ryan Isaac:
With pants only. Okay.

Matt Mulcock:
Pants-only fashion show, I like that.

Rabih Dimachki:
Exactly. What type of pants will make you win that award? And the first question, is it pants? Because if it’s not pants, you’re gonna be disqualified, right? So when we’re saying, “is it pants?” it means are you investing in stocks to start with? Let’s limit this conversation to stocks to the market. And just the fact that you have pants will not guarantee whether you win or not. And pants, we’ve got different sizes, different styles, different quality of the material, and whether it’s trendy or not. You know? Gen Z versus millennial fashion choices. So given all these differences, those would be “factors” that would determine whether your pants are the best pants in the award show and whether you’re gonna be winning or not. The same logic applies to stocks. If you are looking at the stock market itself, there are different factors such as whether the company is small or large, whether the company is growing too quickly or is well established and has multiple revenue streams in the market, whether the company makes money or not, and whether there are people backing it and they buy into the idea. These factors on top of it just being sensitive to the market AKA riskier or less risky than the market, determine whether this stock will be more profitable or not.

Ryan Isaac:
Yeah. What I like thinking about sometimes too is thinking about when we say “stocks,” sometimes I can feel like really detached. It feels foreign for a lot of people sometimes. I like thinking about this in terms of I’m gonna buy a dental practice in town and I can buy a big dental practice or a small one, like the size of the dental practice is gonna matter for different reasons. The style of the dental practice in this terms, it really means like, is it cheap or expensive? Is it a premium dental practice selling for 110% of collections or is it kind of a dime one or a smaller one that’s selling for 40% of collections? Does it make money and have high profits or is it like just skimming and there’s like, it’s not a profitable practice, EBITDA’s not very high? Momentum’s cool to think about too. Is it a practice in the community that is growing, that people are attracted to, that is getting referred to, there’s a good network of referrals? It’s the same thing with public companies or stocks, is just buying a dental practice and making these choices. Like, here’s some different reasons that’ll make one practice different from another in the same town. What experience am I looking to have?

Matt Mulcock:
Yeah, sorry, real quick. I feel like if you take nothing else away from this tonight, this is it. This right here, that not all stocks are created equal, we cannot stress that enough. And when you hear people talk about, or you hear like on the news or you hear your friends or whatever talking about stocks just in general or the market, it is so much more complex than that. And I think that is so critical to understand that when people say “the market,” we’ve referenced this a lot, they’re usually referencing the S&P 500, the 500 largest companies just in the US. The global stock market, I believe, we just did this yesterday, Ryan, they were just going north today, whatever yesterday, 15,000 roughly? 15,000 companies in the world that you can invest in in the public markets. And we can kind of boil these down to these different categories. So again, if you take nothing else away from this, I just think it’s that, it’s understanding that it is so much more complex and not every stock is created equal.

Ryan Isaac:
Yeah. And not every stock is appropriate to own at all or in certain quantities or proportions. And so building a portfolio, there is an approach that is appropriate and there could be approaches that are not appropriate for people depending on their goals or situation in life. And so yeah, I think that’s a good takeaway for sure.

Rabih Dimachki:
But the second takeaway, I think, as a teaser for the next slides is, which stocks are the better ones? If they’re not all created equal, which ones should we really be looking at and highlight?

Matt Mulcock:
They’re like, forget max takeaway, let’s focus on that one. [chuckle]

Rabih Dimachki:
No, no, no. I said…

Matt Mulcock:
Let’s make that… No…

[overlapping conversation]

Ryan Isaac:
I’m with Rabih’s takeaway.

Matt Mulcock:
Tell me, Rabih, I wanna know. That’s the main reason I’m here, is for you to tell me what to invest in.

Rabih Dimachki:
[chuckle] Okay. So that’s the analogy. But here is like the real stuff. So factors are literally statistical tools. They’re nothing but a bunch of numbers. Sometimes those numbers will have an economic reasoning behind them for why they explain stock market return beyond then what just the market explains. And sometimes they don’t. Something a little bit technical, there are actually differences. So when we are looking at small company stocks versus large company stocks, and by small, we’re looking at companies that have a market capitalization of like less than 300 million and large company stocks are companies that their size is over 300 million. What they are doing is that they are choosing a bunch of those small stocks and buying them going long, and they’re choosing a bunch of those large company stocks, which are big, and they are shorting them, they are selling them. And the difference in the math creates a portfolio that is more biased to perform well when small company stocks do better. And the opposite is true. If you buy a long company stocks and you short the small company stocks, you create a portfolio that is biased to perform well when big company stocks do well.

Rabih Dimachki:
So that is like, if you guys wanna go do DIY this at home but I don’t recommend it at all, is how you create a factor, statistically speaking. And that factor is supposed to explain the source of return. So now, instead of just looking at the market and assuming they should fall on that straight line, think of it as a 3D graph and even more dimensions that we can’t really visualize. You’ve got the market explaining a portion of that return, you’ve got a portfolio that is biased to small companies explaining another side of that return, and hopefully as you add factors, you would be able to have a bigger image for why the stock performed the way it did. So the market wasn’t enough so they started adding factors. Okay?

Matt Mulcock:
All right. Can I back up really quick, Rabih, really quick? Just one quick thing, just ’cause I think sometimes we take for granted things like when we say “small cap” or “mid cap” or “large cap.” We use terms like “cap,” people are like, what does that mean? Just really quick, just so people know, when we say “cap,” it’s short for capitalization, and the two inputs. So if you ever hear someone talk about it, you heard on the news or whatever, someone at the water cooler at work wants to talk about, they use this term, all that means is there’s two inputs: We take the number of shares outstanding for a stock and we multiply it by the share price, and that comes up with a number, and that’s what we call “market capitalization.” And so that’s what when Rabih says “small cap,” obviously, those companies are gonna be much smaller, either there’s less shares outstanding or a much lower price than a large cap, let’s say like an apple, right? So, Rabih, tell me if I missed anything there or anything else you’d add, but I just wanna make sure we’re explaining that when we start using things like cap or capitalization.

Rabih Dimachki:
Yeah. No, you’re right. Small cap was just a company that is small in its value. Ignore the finance lingo and just take it for the absolute value…

Ryan Isaac:
Small company. Yeah. Big company, small company. Yep.

Matt Mulcock:
Small company. Yep.

Rabih Dimachki:
Exactly. I don’t know if anyone noticed at the beginning of the presentation, I had a formula on and it was just this portion, the left-hand side of the formula. And as we started adding factors, we just increased the formula and made it just more and more complicated. So this was the answer of academics. They’re like, “The market doesn’t explain everything on how the stock should move, so let’s just add a bunch of stuff to the equation and the hopes that we explain it.” This is one of the few inventions in finance that went from academia into practice. Usually they see practitioners doing something and academics try to create a theory, this was the other way around, one of the few things that went the other way around, which is funny because the next side is about a deep dive about the factors. How many factors do you think exists? If the academics solution was, let’s add factors [chuckle] that would explain the stock return and not only depend on markets return to explain it, how many factors do you think exists?

Matt Mulcock:
All I know is I think people are seeing deep dive and they’re like, “Oh, now we’re doing a deep dive?”

[overlapping conversation]

[laughter]

Ryan Isaac:
Anyway, that was the shallow. We were shallow before.

Matt Mulcock:
Like, “What did we just do?”

[laughter]

Rabih Dimachki:
Okay. Yeah.

Matt Mulcock:
How many factors, Rabih, you’re saying?

Rabih Dimachki:
Yeah.

Ryan Isaac:
There’s gotta be, what? I’m just gonna throw it out there. Multiple dozens? 100? I don’t know.

Rabih Dimachki:
So it is funny because you can just bunch up a number of data through them in a statistical machine, and if that machine works just enough, you’ll call it a factor. What happened is that there is something now called the factor zoo, there are over 400 factors that actually exist in academic papers.

[laughter]

Rabih Dimachki:
They passed the statistical test. They might have an economic justification behind them, they might not. Right? So out of all these 400, there are… Sorry, I have an allergy. There are actually a couple that are the rock stars of this factor zoo. The factors that not only pass the statistical test but actually have an economic meaning for them, and they explain why a stock performs better than another. So I have… Yeah, go ahead.

Matt Mulcock:
Oh, sorry, Rabih. Another thing here is, I think a lot of times these can actually be really intuitive as well, right? So just like for example, let’s take the small company premium for a factor, I think it’s pretty intuitive to say a company that’s small that has a lower price, would have a lot more runway in front of it to grow. Amazon at one point was a very small company in the late ’90s, early 2000s, it would be considered a small company, and then it obviously turned into a very large company. And that transformation of going from small to big means that company did really, really well, right? So I think it’s also… It’s kind of intuitive. Same thing with profitability, the more profit… Ryan, you were saying earlier, the more profitable a dental practice is, the more valuable it’s going to be moving forward. So I think a lot of these, again, are actually rather intuitive, if we just break them that way.

Rabih Dimachki:
They are. They are. You mentioned small company profitability, equity [0:24:26.3] ____ just tells you whether you’re investing in equity versus bonds. And we’ve talked about this so many times. On the long run, equities are gonna give you 7-8% real return, so that’s the premium that comes from equities. For momentum, I don’t know if you’ve seen the main stocks a couple of years ago when there are a lot of people just herding behind a certain investment, they will drive the price up, although it creates a bubble. That’s a risk premium because if you were participating in the upside, you would capture return.

Rabih Dimachki:
The other three are in a different color because they are not equities but they are the most important. Term risk premium and credit risk premium are actually in bonds. I just wanted to mention them really quick. And those explain why a government bond gives you the return that it gives you, and why a corporate bond, which has the credit component and it gives you a higher return than the treasury bond, and they both give you the yield to maturity that they provide as well as the liquidity risk premium, and this is what we see in those private equity and [0:25:27.0] ____ deals that lock your money up for 10-15 years and then you can access the money. The fact that you don’t have access to that liquidity, you need to be compensated for it as an investor, and that’s where the premium comes in.

Rabih Dimachki:
So those are premiums that statistically makes sense. You can create those long short portfolios out of, but they also have a justification. When I said deep dive, this is what I meant. And we kind of touched upon it. What is the economic justification of value size, profitability and momentum? And I just wanted to give reasons for them, and it shouldn’t be long. For value, we’re looking at companies that are well established in the system. When you think of a value company, your thinking of companies like Costco and Axon and Walmart, companies that have been there for a long period of time. They don’t depend on an industry that’s growing continuously, or they are just depending on the market that they function and the competition they are against to make their money. So because they aren’t supported by a hype of a new industry like AI, the market doesn’t really buy their stocks a lot. It’s in the hindsight. They just leave their stocks and not touch them, which puts them in a position where their price compared to the actual value on the balance sheet is much smaller. And companies like Apple and Nvidia and Tesla, which all the hype is all about, those are companies where everyone is buying them, inflating their price compared to their actual balance sheet value.

Rabih Dimachki:
So the difference between companies with a high price to balance sheet or a low price to balance sheet, the PB, is how do we differentiate between value stocks and growth stocks. And data has shown us that tilting your portfolio more towards value stocks has given on average 2% more on a long-term period. So the reason value stocks are gonna give you a 2% more on average is because there isn’t really growth in the industry, they really have to do business as it’s supposed to be, so they might be companies that are financially distressed or they don’t have growth. They really have to be innovative with their products to sell more. So they have low growth prospects. And they are in industries that are cyclical because the economy is cyclical. It’s not something that just growing ahead and making the way easier. And because of these risks that the company is facing, you expect the return you get from their stock to be higher. So the more financial hardship a stock is facing, the more an investor would want to be compensated to buy that stock. And that’s why a value risk premium shows in markets show statistically and actually has an economic justification. Do you guys have any comments before I jump to…

Ryan Isaac:
Yeah. No. We’ve been doing this at this conference a lot this week, talking about the difference in return. So you said historically, the data shows us that a value stock… Which the word “value” is always funny to me because they should have just called it cheap. They were trying to be nice, I think. They should just call it cheap and expensive stocks. They call it big and small, large cap, big cap, large companies, small companies, but they call this growth and value, they should just call it expensive and cheap for everyone playing along at home. But what’s really interesting when you say the data and the history show us that a value stock or a cheaper stock, because it has more potential over long periods of time has returned an average of 2% more than more expensive stocks, the difference in dollars of that, if you had a million bucks invested over 20 years and you had a 2% difference, that comes out to over… It’s like a $2.1 million difference. So you can end up with, it was like 4.6 million, or you can end up with $6.7 million.

Ryan Isaac:
It’s a difference of a lot of dollars, even though 2% might sound like, “Well, what’s the big difference if I get 2% over the course of my investing career?” It’s a massive difference in dollars, in the actual dollars you end up with, it’s a massive difference. Which is why all of these things, again, matters so much to understand and build into your portfolio the right way because that can make a very, very large difference in your future net worth.

Matt Mulcock:
I also think it’s important to that point, Ryan, ’cause I think an intuitive question here would be like, “Okay, cool, well, why don’t I just do this then? If value generates 2% on average more in returns than in grown stocks… ”

Ryan Isaac:
Only own value. Yeah, why not? Yeah.

Matt Mulcock:
Only own value. And I know we’ll get more into it. But small cap value, right? That asset class generates better returns than everything over a 30, 40 plus year period. So again, I think a natural question would be, “Well, why don’t I just own that compared to everything else?” which I think is again a worthy question. But I think the key here to understand is that… And Rabih, you again, I apologize if I’m jumping ahead on you, Rabih, but I think the key here of these factors is they don’t come consistently. They’re not happening every year. They’re not happening even every five years, every decade. You’re gonna have to withstand, like for example, just what we’re talking about, value versus growth. Growth has been dominating value, right? Rabih, pretty much for the last 10 years…

Rabih Dimachki:
Expensive over cheap, yeah.

Matt Mulcock:
Yeah. The expensive stocks, the tech, the big sexy names have been beating value-type companies for the last decade-ish or more. And to the point where people are saying, is this premium even still a lot… Is this even still a thing? People are questioning it. So I bring that up to say, it’s really easy to look at historical data and say, “Oh, I’ll just go on that.” And I think you will be better off over the next 30, 40 years if you have these tilts or this strategy, but you have to also withstand. You have to have kind of this discipline, this strong stomach to go through times like what we’re going through right now, and a strong belief system to say… You never know when the premium is gonna show up. It will show up based on data and evidence, but you don’t know when it will and how frequently or consistent that it will.

Ryan Isaac:
Yep. That’s perfect. It’s the same question if someone’s like, “Well, did you see Bitcoin up one up 1000%? Why don’t I just put all my money in the thing that’s clearly doing the best right now?” It’s like, well, ’cause it doesn’t always do that. And when it’s bad, it can be really bad for a long time, and you don’t wanna be… That’s what diversification is. That’s why you build all of these things into your whole basket of portfolio and investments. So, anyway, yeah, that’s really good.

Matt Mulcock:
Sorry, Rabih, we’re going off track. Bring us back. Bring us back.

Ryan Isaac:
We got 20 minutes we had like… [chuckle]

Matt Mulcock:
Yeah.

Rabih Dimachki:
Okay. Well, what you mentioned is really interesting. I just want to highlight one point. Not any value company is gonna out-perform an expensive company and growth company. You have to think of this with a pre-requisite of diversification. We’re talking about a diversified value portfolio versus a diversified growth portfolio or an expensive company portfolio. And when that mentioned long-term horizons, it’s because you don’t know how it will show up, and actually in 2022 value did better than growth but not because they went up. The S&P 500 which… Or let’s take the Russell 1000 growth, which is the growth index was down 30% in 2022. Whereas the Dow Jones, which is tilted towards value was only down 8%. So that 22% difference is an out-performance for value although your portfolio was still down 8% for the year.

Rabih Dimachki:
So you really don’t know when it’ll show up. And what’s important is that at the end of this long-term horizon, your portfolio is doing much better. Now, moving on to size, we talked about it, that it is about companies that are smaller in size, but the reason there is an economic justification for why they make more money, because that company is riskier. If it’s smaller, it’s riskier because it’s less diversified in terms of the different revenues that it generates. They don’t have access to capital. Not every bank is willing to loan that small company money ’cause they are small, they are risky. And because they are small, it means that they were in industries that aren’t really established yet. It’s an industry that’s still growing and they need to prove themselves against competition. Because of these risks, investors need to be compensated, and that’s why you have higher expected returns assumed in a smaller company, and that’s why data shows that they do out-perform on a longer term horizon.

Rabih Dimachki:
The third point is profitability. And when we are talking about profitable companies, we’re talking about companies that have lots of cash flow. They have lots of cash flow to fund their assets and keep their business running. But on top of that, they have enough to think of new opportunities and invest in the next technology and the next opportunity for growth. And those companies who create a lot of cash flow that is in excess of what they need to run their business actually are in a better competitive position. They can sustain their growth and investors prefer them. And because of that, also on long-term horizons, they have shown to provide better expected returns than companies that don’t make money. And what I’m saying of profitability stocks, it doesn’t matter. A good example would be Tesla and Uber. Tesla makes money right now, and Uber didn’t make money until just recently. They are both like fancy companies that everyone loves. They’re saying they are the future, but one is making money versus one hasn’t been making money. And the performance of a Tesla stock versus an Uber Stock is very evident of that economic justification in action. You guys have any comments?

Ryan Isaac:
No, I mean, no… Yeah, grab a glass of water, man. We’re making you do all the talking. I like to pause throughout this and just go, What’s the takeaway here? We said that were saying this earlier, Matt add to this after, but I like to just keep reminding us. This is just like… Yeah, stay there for a second. We’re in the era of… The era… And I can’t stop thinking about sales. So we’re in the DSO era, and this is the kind of selection of DSO is doing depending on what kind of DSO it is. They’re out there looking at value practices. Do we want cheap ones or do we wanna buy the expensive premium ones? Do we want big practices in our portfolio, or do we want small ones? Do we want high profit where the owners are just taking home loads of cash, or do we want low profit because they’re dumping all the cash back into the business and hopefully growing really faster? Do we wanna practice since it have a lot of momentum and its growth like really fast, fast growth?

Ryan Isaac:
So these principles, you’re probably more familiar with these in the dental world, and these make sense in the applicable dental world. But this is how picking stocks in a portfolio works too. And I just kinda like to point us out again, because these are things you’re familiar with in the dental world that go on in the stock market world, just the exact same. And all these different things will have totally different outcomes depending on which ones you put in your portfolio and how many of them and in what proportion. So I like to just pause and remind us that’s a takeaway. These are some of the characteristics that make stocks different just like a dental practice.

Matt Mulcock:
Are you waiting for me, Rabih?

Rabih Dimachki:
Yeah, I can go. [chuckle]

Matt Mulcock:
Yeah. No. Let’s… No, I think that’s an incredible point. And I think mainly because people, again, get confused when they hear the stock market. They don’t really think, again, intuitively of what it actually is. And Ryan, you just said it perfectly, that all these are just companies just like your… They’re just businesses, just like a dental practice. And so I think that’s, again, a really key takeaway there. So, yeah, Rabih, let’s keep moving.

Rabih Dimachki:
The last factor, it’s very important, but it’s economic justification is actually behavioral rather than based on the balance sheet. We’ve talked with the last three, we’re looking at cashflow, we’re looking at the size, we’re looking at why the balance sheet is relative to the price of the stock. They are all on the financial statements that you see in the company. Whereas momentum, it’s very interesting. It’s behavioral. And that’s why it only shows up on short to medium term horizons, like Nvidia right now with the stock going up and everyone just jumping on the bandwagon investing in Nvidia. So momentum stocks are usually the winners. There’s a herding behavior. Everyone wants to jump on that train. Momentum shows up when a stock market crashes or it’s on the brink of a bubble where there are overreactions and under-reactions from investors.

Rabih Dimachki:
And because information is diffused differently, institutional investors with access to news agencies get the information much faster than the retail investor who’s under their Robinhood account, right? So because information diffuses into the market differently, you won’t get all the buy orders or all the sell orders at the same time. They’ll come one after each other, and that’s creating momentum, and it affects stock prices. It explains stock prices just like value, size, profitability, and the overall market do.

Rabih Dimachki:
So now, why are factors important? And I’ve been telling you the data that they test. So now is the time to show you the data. And there are two important ways to look at it. And I will be describing this graph in a second. There are four different sections. The section that says market [0:39:41.0] ____, we’re just talking about the benefit of buying the stock market versus buying bonds, right? Buying treasury bills. And over a one-year period, 70% of the time you expect the market to beat. If you buy stocks, you are 70% of the time you are better off than just buying bonds. On a five-year holding period, you are 79% better better off buying the market than bonds. And over a 10-year holding period, you are 86% more likely to be better if you held stocks for 10 years, rather than holding the treasury bills for 10 years. This is the logic…

Matt Mulcock:
If you’ve been out to 15 years beyond, Rabih, it doesn’t show here, but I think that’s 100%. Right?

Rabih Dimachki:
It is 99.97. Yeah. Yeah. It’s almost a hundred. So this upper left is just telling you about the equities premium, the benefits of choosing equities over treasury bills, right? As it pans to start with. That’s the logic. The second point is value beating growth, which is buying companies that are cheap versus companies that are expensive. When you are looking at their price relative to their balance sheets, on a one-year holding period, you are 60% better off being in value. On a five-year period, 70%. On a 10-year period, you are 80% better. That also here, small beating large, investing in a smaller company versus a large company, 56% of the time you are better off in one year. 60% of the time if you’re holding horizon is five years, and 69% of the time over 10 years. So assuming you are going to a casino and you’re gambling and you are looking at these odds, would you choose to be in a small versus a large, a value versus a growth? And this is what the data tells us. It’s self-evident, right? And the last…

Ryan Isaac:
Yeah, especially… Oh, sorry, really fast. I just wanna… I want to make a point… Shoot, I should have just waited until you finished this so you can have some water. I just wanted to make a point that the longer out, all the charts that we’re looking at are showing everything like you’re saying in one-, five-, and 10-year increments. And the longer you go out, the higher your probability and your odds go. And when you think about what is an investing time horizon for people, I know it feels crazy to think that people will invest money for 50 plus years, but you will invest money for 30 years of your career. You’re likely gonna live decades after your career is finished, that your money will remain invested. And if you pass money on to heirs or charities or children or whatever, that money also remains invested. So when we’re talking about…

Matt Mulcock:
70, 80 years we’re talking, yeah.

Ryan Isaac:
Exactly. So when we’re saying like a 10-year period of time, your odds start going up into the 70s and 80% and 90% probability range of having a successful outcome. We’re talking about 10 years of multiple 10-year periods, decades and decades of your investing lifetime. It seems long, but that’s actually just a sliver. And it’s just, to me, this another takeaway. This just tells me, it reminds me again that our biggest struggle as investors is just sticking with it long enough. If we do, the odds are so incredibly in our favor. And the compounding over that many years is, I mean, that’s why Warren Buffett is what he is. He’s a genius, but he is also just super old and he’s done it for a long time. So this just shows me the odds of sticking with it and how important it is.

Matt Mulcock:
Also the other part of this too is really key to talk about. We’re talking about these percentages. We’re talking about putting the odds in your favor. When we were at one of these presentations we had during this workshop, one of the speakers made a really good point. He was talking about how he’s been really focused on getting healthier as he’s getting older, right? He stopped smoking, he eats healthier, he works out more. And he literally just asked the question, why would I do that? He could go out and get hit by a bus tomorrow. Does it guarantee that he’s going to live for the next 30, 40 years? No, of course it doesn’t. But he’s doing it to increase the odds of his success. And I think a lot of times with investing, we want certainty. We want narratives that make sense. We want to know what is the best investment, this over that.

Matt Mulcock:
And I think it’s really, really important that they’re like… This is what we’re talking about or looking at. This is what Rabih’s looking at all the time when we’re building portfolios or managing money. And the same way we’d want you to look at is, all this is, is saying how do we increase the odds of success? That is it. And it’s not gonna be a guarantee. But as to Ryan’s point, time is the secret here. The more time you have, the more those odds are gonna be in your favor. Again, I’d imagine, Rabih, that each one of these, if you we’re only showing up to 10 years, but if you go out to 15, 20, 30 years and beyond, I’m gonna guess that these are all close to 100% or close, right? At least close to 100% success rate?

Ryan Isaac:
Yeah, Matt, I wanna just add on what you said ’cause I think it’s really important. We’re here tonight talking about the technical, logistical, strategic things that we do to increase our odds inside of a portfolio. That’s asset management. That’s investment management. That is one of our jobs at Dentist Advisors for all of our hundreds and hundreds of clients all over the country. The job of a financial advisor or a planner or a coach, however you wanna call us, our job is to make sure once we’ve built our portfolios, to give us the greatest odds that we help you stick with it long enough. ‘Cause you can build the best portfolio in the world, but if you’re not gonna own it long enough, if you’re gonna jump in and out of it and be inconsistent with your saving, you won’t have this investment experience.

Ryan Isaac:
So there’s two jobs to be done here. There’s the job of investment management and construction and strategy, and then there’s the human behavior which is usually solved by organization, lots of communication, discussing big decisions, discussing times of stress, decision making, anxiety, making sure that you stick to things and that your behavior, you don’t self-destruct, you don’t self-sabotage your own investment plan that’s been built beautifully by Rabih in the first place. So I like that you brought that up, Matt, about designing things to be in our best odds. But there’s two pieces to this. There’s the strategic logistics of a portfolio, and then there’s the human behavior that has to come with it or else it doesn’t matter.

Matt Mulcock:
Yep, for sure. Okay, Rabih, sorry. Keep going. We keep…

[overlapping conversation]

Rabih Dimachki:
No, it’s fine. No, this is…

Ryan Isaac:
Nine minutes. No big deal.

Rabih Dimachki:
No, I still have one more slide.

Ryan Isaac:
Okay. Good. Perfect.

Rabih Dimachki:
This is a very important point because all this work will go in vain if it wasn’t for the behavioral oversight sticking to the plan, right?

Ryan Isaac:
Yes. Yes.

Rabih Dimachki:
The same point goes with profitability. I see you guys, I guess you see the point, the longer you hold it, high profitability stocks are gonna beat low profitability stocks. So back to Matt’s point where he said, we are trying to make sure the odds are in our favor, this is the first way we’re making sure the odds is in our favor. The second way we’re making sure the odds are in our favor is by looking at the premium. So let me explain this graph really quickly. The blue line means positive, red is negative, but this doesn’t mean that it made money. It just means that an example in the first one, equities did better than bills.

Ryan Isaac:
Can I pause really fast? For the people listening to the podcast, we’re looking at a graph that runs left to right along just horizontally, left to right. And from left to right, it’s just years that go by, right? We’re starting in, oh, 1932 all the way up until 2022. So left to right, 1932 to 2022. And we’re just seeing the times that each one of these factors, small, cheap, expensive, whatever, profitability had a positive outcome over not. Yeah.

Rabih Dimachki:
Yeah. Had a positive outcome over the other asset class…

Ryan Isaac:
Over the other one that…

[overlapping conversation]

Ryan Isaac:
Yeah. Okay.

Rabih Dimachki:
So what we are seeing, what shows up here that it’s up 20, it doesn’t mean the equities did 20%, but if you shorted bonds and went into equities, you made 20%, right? So this is how you look at the factor. And each one of these bars is a five-year holding period. So we are looking at the middle line in each of these graphs. At the five-year holding period, this is how equity risk premium looks like, small versus large companies, value versus growth, and profitability. There’s no data for it because reporting standards weren’t created back then. So what is interesting, now we were looking at it horizontally, look at it vertically. What is the probability if you look at them year by year, that all four of them are read at the same time?

Ryan Isaac:
Oh yeah, zero. They’re not correlated. They don’t do the same thing at the same time.

Rabih Dimachki:
They are not 100%. So the other benefit of investing in factors and adding factors to your portfolio is that you will enhance your diversification abilities, simply because the historical performance of these premiums is so uncorrelated that in times when the market is down over a five-year period, investing in value in small cap and investing in value as well as high profitability companies gave you a good cushion, a good buffer to withstand recession such as the one we’re pointing at here, it’s the dot com bubble, right? So just because you are adding these factors to your portfolio, you are enhancing diversification and you’re not just adding stuff that don’t make sense that enhance diversification, you’re actually adding factors that have good odds as we saw in the last slide.

Rabih Dimachki:
And this is really the step beyond indexing and why people like Warren Buffet we’re able to outperform the market by, and not just by the index. And now those exist in multiple ETFs around the world. Dimensional Fund Advisors, the conference you guys are at is one of the people who focus on these strategies. And we at Dentist Advisors are trying to find managers who are executing and implementing such academic research in a profitable way. So we have them in our portfolios.

Ryan Isaac:
Yeah. I just want to give some context for people just listening too, but even watching this along. I’m looking at the chart that is representing the years where value stocks, cheap stocks outperformed, or how the higher performance than growth stocks expensive, so the years that cheap stocks outperform expensive stocks. And in this chart that runs left to right from… It’s 90 years, 1932 to 2022, there’s these bars that either go above the horizon, like they go upwards, which means that it outperform and they go down, which means it underperformed. If you look at this, you just visually you see way more upward facing bars that are blue that show us visually that there’s no question this outperforms over long periods of time. I counted them. And it ends up being about 13% of the time over 90 years that it didn’t perform, that expensive stocks beat cheap stocks.

Ryan Isaac:
But so, they’re huge percentage of time, 87% of the time, over 90 years, cheaper stocks are outperforming more expensive stocks. And I just think that… And what that means, it’s 60 years out of 450 or 60 periods out of… So it’s like, it’s such a… If you see this visually but you see the numbers too, it’s such an obvious thing. But what you were just saying too, Rabih, just to reiterate, the times where value didn’t outperform growth is not the same time that small caps did outperform large caps. And it’s not the same time that bonds outperformed stocks. They kind of moved in different sequences, never at the same time. Which again, this is why diversification matters so much. It’s like the times when the US didn’t do so great, other parts of the world did; or when big companies in the US did terrible, small companies in the US did better. And so that’s where diversification just… It tells such a compelling story for that.

Matt Mulcock:
We almost do ourselves a disservice sometimes I think by meaning like us as Dentist Advisors, where we almost simplify this to a point of saying, “Oh, just index,” like, “Just buy the index,” right? Like the S&P or whatever it is, like this is a big thing nowadays, we’re just indexing. What we’re describing here is I’d say, and Rabih, tell me if you think this is an incorrect characterization, but I’d say has the framework of indexing. We definitely, certainly believe in the framework or the foundation of buying a large group of stocks in the market. But there’s so much more nuance to it in what you’re describing here. And we could do hours of content on this, right? But having the framework of indexing for sure, but there’s so much more of what you’re describing here with the kind of taking it a step beyond that and not just buying the index and letting it sit, but also tilting or having these factors involved as well. I think it’s important.

Matt Mulcock:
Yeah. The way we describe this is not active, but we’re also not passive. I think the way we describe this is systematic investing, right? Or maybe there’s another word, Rabih, you’d use, but I think systematic, evidence-based would be one way as well. We’re somewhere sitting in the middle. Our belief system is, there’s needs to be more activity or intention than just passively sitting in an index, but also we don’t believe in market timing or active management.

Ryan Isaac:
They’re different things.

Matt Mulcock:
They’re different things. Yeah.

Ryan Isaac:
Yeah, these are all very, very different things. And so we all need some…

Matt Mulcock:
Rabih, close us out, Rabih. What else? Anything we missed there, things you want, any final thoughts?

Rabih Dimachki:
What you guys said is very true. Actually, if you get an index and you compare it to a properly globally diversified portfolio, both of them are gonna have the 15,000 stocks in them. If you look at the names, they are the same names. You won’t find the difference. The difference is gonna be in the waiting, and the waiting is determined by each stock’s exposure to that factor. And we’re talking about big, big spreadsheets right here. But this is the difference. It’s not that we’re cherry picking stocks, we are still buying the whole market like the index does. We’re just slightly shifting the weights in order to capture higher expected returns shown in value premiums, in small company premiums, in profitability. And we are trading in a smart way to work around momentum. So that’s about it.

Ryan Isaac:
Yeah. Thanks for joining us. If you have any questions, dentistadvisors.com. We’ll catch you next time in another episode at Dentist Money Show. Bye-bye now.

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