Investing In The Modern World: Ep. 1

Hey, dental associates and new practice owners. Welcome to the Associates on Fire podcast, powered by Practice cfo. This is the podcast that teaches you what you never learned in dental school, the financial side of dentistry. We cover topics from planning for ownership, buying a practice, to student loans, taxes, and all things financial for the hungry to learn Dental Associate. So let's light it up.

Welcome back, everybody, to the Associates on Fire podcast. My name is Drew Phillips and I will be the host of today's episode. For those who haven't had a chance to check out our Associates on Fire program yet, I'm a CPA and CFO advisor at Practice CFO and one of the instructors in our Associates on Fire program. Be sure to check us out at www.associatesonfire.com. guys, today I'm super excited. And the reason is that we have not only a good friend of mine on the show, but also one of my colleagues at Practice cfo, Brandon Hobson. Brandon is our investment director and he is one course away, one test away from being a Chartered Financial Analyst, which is, in the finance world, one of the highest designations. And I can't express enough, you know, how awesome and fortunate we are at Practice CFO to have someone of Brandon's caliber and knowledge and background to be on our team and help facilitate our investment strategy and the allocation design and investment portfolio design for our clients. And everybody that works at Practice CFO just benefits greatly by having Brandon as a resource to rely on. So, without any further ado, I want to welcome Mr. Brandon Hobson.

Thanks, Drew. I appreciate it. I'm happy to be here today and excited to talk about our agenda.

We have a really cool agenda and we've tailored this for the audience. We've tailored this to be in line with what you are likely seeing on headlines right now, which is inflation. Inflation, inflation, interest rates, Federal Reserve policy. What is happening government in the sort of entire economic system right now is definitely top of the headlines. So part of our segment's going to be focused on that and then part of our segments going to be focused on how Practice CFO and Brandon and his investment approach is going to be tailored to this current environment. And we will talk about anything in between as well. So to start, Brandon, I want to talk about inflation because inflation is a huge, huge, huge headline right now. We're experiencing. In fact, I think I saw a headline the other day. It was like 6.2% was the inflation increase year over year, which is the highest it's been in 30 years, right?

Yep, that's right.

So you know, talk to us about inflation. What does it mean? You know, is it all fugazi? What's happening?

Yeah, yeah. So inflation is an interesting topic that we haven't had to talk about for, you know, probably about two decades, really, because 1991 is the year that you're referring to when inflation was as high as it is today. And that was just reported in the Wall Street Journal yesterday. And, you know, what the Fed is saying on inflation is that it's transitory, essentially. They're saying that the economy is heating up and people are coming back to work. Supply chains are constrained, which basically reduces the amount of supply. So, you know, simple example, if you need a refrigerator right now, you go to buy a refrigerator. There are a lot of other people in the country looking for refrigerators, and there are not enough refrigerators for the demand. And so what happens is the price obviously rises so that demand eventually will fall and meet that supply. And so what we have now is, you know, the Fed starting to pivot a little bit because they thought it was transitory. And, you know, we're just adjusting as we go as we see the data. And there are some signs now that this could be what they're calling persistent inflation now. So it could persist possibly into 2022. You know, 2023.

Inflation overall is not a. It's not a terrible thing.

There are certain types of inflation worse than others. For example, labor inflation, when wages start rising, that is typically a bad sign. And I say typically because that was what caused mass inflation in the, in the 70s, which became a huge problem for the country. And we are starting to see wage inflation tick up. And that's new, that's more recent. At first, wages were not really rising as fast, and now they're starting to pick up. And so that's a little concerning. But overall, you know, we're just taking the data as we go. Same with the Fed, I do expect they're going to start hiking interest rates in 2022 to kind of combat this inflation. And also they're starting to taper, which is really prepping them to get ready to hike rates.

So I think you made a really good point. And most of our listeners, not, maybe not all of them, but a lot of them are practice owning dentists. Right. Who have staff members. And I worked very closely with them in terms of their hiring process, scaling their business. And I know one of the things that have been coming up a lot recently in our meetings and phone calls is increased wage expectations from new hires. Hygienists are expecting more money an hour, more money per day, guaranteed. You're getting the same from assistance and front office personnel. So I think that your point on wage inflation.

Really hits home for our audience because they're experiencing this right now as they're doing interviews probably today.

Step back just a moment. With wage inflation, you said that that type of inflation may be a little bit more problematic and help our audience understand maybe why that type of inflation may be more problematic than say, inflation on goods or services.

Yeah, so wage inflation is basically, wages are a big component of the overall economy. So once they start to rise, you know, material prices are important as well. But what the Fed is kind of saying right now is that those are going to subside as we can ramp up demand or, sorry, ramp up supply, if you will. Some of those demand caused inflationary pressures will subside. Now with wages, you kind of have a couple things going on. One, there's a push to increase the overall minimum wage and in all aspects of business, including the federal government. And so there's really not too much of an indication that. And wages are very difficult to reduce once you raise them. Right. And so you can imagine if you hire a hygienist today in a inflationary, wage, inflationary environment, it's going to be very difficult, if not impossible, to cut her salary when those inflationary pressures dissipate without causing some staffing issues and possibly losing your employees. And so that's the biggest risk there. And that's why the focus is on labor inflation for the most part, because it's such a huge input into the manufacturing process or the service business, as in dentistry.

So you're saying it's such a big process and I agree. I mean, when you, after you, I mean, who wants to get a wage reduction, right? And I know, and I cannot, but I feel, and I sympathize with the people that are practice owning dentists are trying to hire. I do, because they're facing increasing prices at the grocery store store, at the gas pump. And, and so I do realize that, you know, they're having forces that are outside of their control and they're just trying to basically stay above water with the wage increase. And I think to tie in what you said sort of briefly, which is transitory inflation, which so many economists and so many financial professionals, including even you, I believe, thought that transitory inflation was, was, is actually what was happening in our economy. It wasn't real or, or persistent inflation. It was actually, you know, just momentary due to the economy overheating. As it comes back from this odd Covid down period. And to your point, you know, resisting the urge to pay someone a higher wage when we feel that this inflation is transitory, while it may be hard to keep people around at the moment, is probably a decent strategy if in fact this inflation is transitory. So what causes you to believe, if you still do believe that the inflation we're experiencing right now is transitory, what do you believe is causing that type of inflation to occur?

The transitory inflation, specifically?

Yeah. Why do you think it's transitory?

Yeah. So, I mean, right now it's a little bit difficult to determine whether or not it is truly transitory. You know, the Fed is also trying to figure that out. I would say the number one thing that leads us to think that it is transitory is the fact that we know that supply chains are constrained. You know, for example, there's a massive chip shortage and chips pretty much go into everything these days, technology wise. There are also, you know, I believe it was early September where unemployment benefits expired that were basically keeping some workers on the sideline. And that's. It's only been a couple of months since that those unemployment benefits have expired. And so it takes some time for that to play out. You know, are those workers going to come off the sidelines now or are they, did they have enough money saved up during the COVID crisis to kind of sit out for another six months, you know, because that's going to make a huge difference as to whether or not our supply chain constraints start to relieve themselves sooner rather than later.

Right. Because we don't have, if there's no employees, they're all on the sidelines, who's there to help make and manufacture the products that we need to keep the world going around.

Exactly, exactly. And then you increase wages in order to get them off the sidelines, you know, and there comes your labor and inflation.

So Brandon, when in what about the travel? Right. I mean, we're. The US just opened its borders right back up to foreign travelers. And I mean, of course they're required to have a vaccine. But you know, I went to Europe this summer in July, and they required to have a vaccine and they opened their borders earlier. But for the better part of a year, you know, we were all in our homes not traveling. And while we did have a lot of unemployment that occurred as a result of the lockdown and the shutdown period with all the stimulus money that was, that was received and issued by the government. Right. It did sort of mask, if you will, the down period that we experienced during the COVID closure periods.

And so with that, without. With the money supply staying consistent, but with people not traveling abroad. Right. As much as Americans love to do, and we're now stationed here and having nowhere else to spend our money but in America.

Right.

And what does that do?

Yeah, that's, that's a good point. I mean, that. That causes more inflationary pressure as well. And you can imagine that, you know, for a while there, as we became more of a global economy, meaning, you know, all of our economies kind of integrated with China, India and all these other countries, it became much easier to travel. You know, travel restrictions were not, were not high until Covid hit. So what that led to was a lot more Americans traveling outside the country and spending their money outside of our borders. When that ended, you know, people couldn't leave and spend money in other countries, and so they were left to spend their money inside the borders. And when you leave the country, you basically exchange your dollars for the first foreign currency of the country that you're visiting that country. Then their currency demand increases and it increases the value of that currency and reduces the value of the US Dollar because the demand for the dollar falls. Assuming that more Americans are traveling outside than people are traveling in our borders, the overall impact there is going to be a decrease in the dollar and an increase in the foreign currencies. You know, that hasn't been happening. And so hopefully, as we see some of these travel restrictions get lifted now, that that could also lead to some deflationary or what they call disinflation. It's not necessary deflation, because you're still going to have inflation. It's just less accelerated than what it is today. So we should see inflation fall a little bit as people start to travel and spend their money outside of the borders.

With the working situation that Covid caused, with the travel restrictions that it. That we just spoke about, all of these factors are leading to you and a lot of the reputable economists and financial providers out in the, in our world to lead them to believe that this inflation is in fact, transitory for those, for those reasons. And there are other, other ones, but those are some of the larger ones or main, main ones that come to mind.

So with this increase in inflation, with all these pressures that are at our doorstep right now, what is the role the Federal Reserve, not only in general, but as it relates to what we were talking about with inflation, what is their role to help ease inflation to some extent?

Yeah, that's a good question. So The Federal Reserve has a few tools that they, that they can use to help ease inflation. And really their goal, the Federal Reserve's goal, is to cool down an overheated economy. So it's very different the current environment that we're in relative to what the, the Fed has had to experience in the past. And by that I mean that inflation typically occurs later in the economic cycle. You know, late expansionary phase is what they call it. And that's common when inflation rises. That's not too long before you're in a recession because the Fed then hikes rates to combat that inflation, which eventually pushes us into a recession and the cycle repeats itself. They cut rates and we, we then enter an expansionary phase. What's different now is that we're currently in an expansion, an early expansion phase, and we're experiencing inflation which is, you know, it's very difficult for the Fed to act because they need to let the economy run in order for it to rebound from the COVID crisis. So they don't want to start hiking rates too early because they know that that could potentially push us into a recession. Also, there's been about 20 years where inflation wasn't an issue or so. And so they want to kind of let inflation run hot to make up for some loss inflation, inflation, if you will, over that period of time. But nonetheless, it's going to come to the point to where they're going to have to start increasing interest rates if inflation doesn't start to subside sooner rather than later. And when that timing is, nobody really knows. And you can really see it in the Fed in the dot plot. When you look at the members and their beliefs in the Fed, they're so different. There's varying degrees of some believe we need to start raising rates by Q2 of 2022. Some don't want to raise rates until 2023. And as things become more clear, hopefully we'll have more of a consensus there and then we'll start to kind of be able to have an expectation on when those rate increases will happen.

And how does the Federal Reserve increase interest rates?

So the Federal Reserve basically controls the overnight rate for banking for the bankers. So banks have to adjust their rates because that's how they make money, right? So if the Fed starts making or increasing interest rates on banking, then the banks are going to then start increasing the rates that they lend in order to pay the Fed for the rate that they have to pay to be able to borrow money. But also they have to make a profit. And so what happens is that when the Fed starts hiking rates, it really starts to show up in the short end of the treasury yield curve.

Yield curve. You know, love that term. What does it mean? What is a yield curve?

Yeah, the yield curve is basically, you know, on a Treasury bond you can buy various maturities. So on the short end, let's call it a two year treasury and then on the long end you have a 30 year treasury bond, like almost like a mortgage, Very much like a mortgage. And then so over that 30 year period, as that duration, and we'll call that duration, is the length of the bond. The longer the duration, the higher the the bond yield. And that makes sense because, you know, if you have a 30 year bond, you expect to get paid more for locking up your money for 30 years. The shorter end of the curve may right now say the 10 year treasury sitting at about 1.5, 1.53. Yeah.

Sort of ticking up a little bit the last couple of days.

Yeah. Especially yesterday, a massive increase when the inflation reports came out. Right. And so that's the market trying to adjust for what they're seeing within the data. Now the treasury doesn't control the long end of the curve. They really don't have much of an impact on that, but inflation does. Inflation has a huge impact on the long end and the Fed does in the fact that they had been buying long term treasury bonds through what they call quantitative easing, which they're starting to lay off of now or starting in November by tapering. So really that's the only impact that the Fed can have on the long end of the curve is through quantitative easing, which is a.

Fairly new process here in this country. Japan has been doing it for quite a while.

For a while, right.

Yeah.

You went over two ways that the Federal Reserve can control interest rates on the short end the curve. They can control them by hiking the overnight rate, which is essentially the lending rate between themselves and other financial institutions, big banks.

Right.

And they can affect the long end of the curve, not maybe as materially as they affect the short end of the curve, but they can affect the long end of the curve through quantitative easing, which they are now starting to do less of. And quantitative easing, essentially the Federal Reserve just buying bonds at the long end of the curve with 30, 25 to 30 year durations. Correct.

Right.

And as you were saying earlier, they're going to start to slow that quantitative easing process and unwind themselves from that long end of the curve buying process. And what does that do to the long end of the Curve as they slow that, as they taper, as you said.

Right, yeah. So just put some numbers on. The Fed has been buying 120 billion in bonds monthly, you know, since this, this pandemic started.

120 billion?

120 billion monthly. That's a large amount you can imagine. 20 billion of that is mortgage backed securities and the other 100 is primarily treasury bonds, we believe. I mean they, the Fed did say that they were willing to purchase corporate debt as well, but. And they haven't been too transparent on whether or not they've been doing a whole lot of purchases in the corporate sector.

But it's for many reasons, I'm sure.

Yeah, yeah, for many reasons. They basically want to send the message to everyone else in the economy that things are good and they're willing to make those purchases. And if, if that message puts markets at ease, then they don't really have to make the purchases because people don't panic and start selling off bonds. And I personally believe that's probably what happened. I don't think they've been making a lot, whole lot of corporate purchases. They've been buying 100 billion in Treasuries roughly, and 20 billion in mortgage backed securities for a total of 120 billion. And when they do that, they're creating demand on the long end of the curve. So these are bond, this is bond demand. That wouldn't be there unless the treasury was starting to put their hand in the market. Yeah.

Who else has got 120 billion to spend on bonds every month?

Not you or me. We're not going to be able to, to make that type of impact on the long end of the curve. But they are. And by increasing that demand, it basically brings down long term interest rates because demand drives interest rates, assuming that supply doesn't outweigh the demand. And so that's why you're seeing the long end of the curve stay relatively low. And the yield curve hasn't steepened quite as much as we would have liked it to steepen coming out of a recession.

And all he means by steepen is when you look at the short end of the curve, it's, or the 10 year, it's at 1.5%. You look at the long 30 end of the curve and it's at 1.72%, right?

Yeah, it's not much.

It's virtually flat. And so we expect the long end of the curve to increase at a faster rate than we do the short end of the curve to adjust for this flatness that we're experiencing right now in the yield curve, so that people are actually getting a higher rate of return for locking in their investments for a 30 year period, as opposed to five to 10.

Right. We've talked about how inflation is potentially transitory, but at the moment it's still very real. We talked about two ways that the Federal Reserve is increasing or potentially increasing interest rates in the short term in the future. Right. And they're increasing these interest rates to combat inflation. And while we said that the inflation that we're experiencing right now may be transitory, there's still pressure from the economy and from the investors and from the consumers to keep inflation under control and that our business owners are experiencing this with wage inflation increases. So it is very real whether or not it's transitory or not. The Federal Reserve does need to respond or does need to have a plan in place, which we believe that they do. And that plan is to increase interest rates. And by increasing interest rates, we're effectively saying that new money is harder to come by because it's more expensive. Right, Right. So we're lowering the demand of, for, to. For new money. And what is that? What does that essentially do? Right. If we have, if they're businesses, which are the core drivers of our GDP and our economic cash flow, if you will, if they don't have as much access to debt because it's more expensive, that then flows down and funnels down to the lower consumer and employee level and they have less funds to go out and spend and buy services and goods, which then in turn lowers inflation. So, Brandon, have I missed anything here? Anything that you would like to add to this topic?

Yeah, I think you hit the nail on the head there. So, I mean, in a nutshell, you can just boil it down to a simple example. And they call this easy money policy is what we've been experiencing for quite a, quite a while now where interest rates are low and interest rates, even the Fed's rate does have an impact on credit card rates. It has an impact on bank lending like we talked about. And so as an individual, if you can borrow money at 5% relative to what may be normal at 12 to 15%, then you're going to be more likely to borrow and spend and that's going to drive demand. So by the Fed hiking those rates, it's going to, you know, like you said, it's going to impact businesses, but it's also going to impact us and every consumer in this country in our daily lives. And maybe we'll be less likely to take our credit cards out of our pockets and swipe them, you know, because we realize that the cost of doing so is increased and that is how it's going to drive down the demand over the long run. But the problem with that is, is it's very difficult to predict. The Fed is basically reacting and hoping that something happens a certain way within a certain timeline. And usually it doesn't quite work that way. So what happens is the Fed will.

You mean the Fed can't predict the future?

They can't predict the future as much as they try to. They can't. And so unfortunately, what happens is historically they tightened too much. By tightening, that's hiking rates, that's just another term for hiking interest rates. And by tightening too much, generally, you constrain demand to the point to where you create a recession. And that is very difficult to unwind after you've, you've basically pushed the economy into a recession, if not impossible. And so that's really the hesitation I think that you're seeing on the Fed right now. They're being very hesitant to start that rate hiking process because they want to be really, really, really certain. They can't be a hundred percent certain, but they want to be very, very sure that this is not transitory inflation before they start hiking those rates.

That's a really good point. And I don't think the Federal Reserve has the best track record when it comes to implementation of monetary policy either.

And look, there's a lot of political pressure there as well. You know, the big banks in this country are extremely powerful and they benefit from increased rates. And the Fed typically will get pressure from the banking industry, the financial sectors to raise rates. You know, so Jerome Powell's got to, and whoever is his assessor, if he's replaced, they have a lot of pressure that they have to deal with when they're making these decisions. And so I think it's easy. Jerome Powell has received his fair share of criticism over the years, but he's got a very difficult task ahead of him.

He does. He definitely does. And then let's talk about, Brandon, what's kind of not, we're not switching gears. It's still in the same train of thought. In fact, it's all so interconnected and directly related related that it's, that it is, does create this sort of circular reference, so to speak. And so I want to talk about how interest rates, as they rise, we did talk about how bank stocks, right. Will likely do pretty well in a rising rate environment.

But how does it Impact the other securities and other companies, corporate companies in America or even abroad. The rising of interest rates, that is.

Yeah, yeah. So you know, like you alluded to, banks will typically benefit because as the long end of the curve, like we Talked about, the 30 year on the treasury curve is that rises, typically banks are borrowing at the shorter end, so those rates are much lower and they're lending on the longer end, which if those rates rise, it increases their margins. Now for you know, non financial industries, inflation, depending on the company, inflation can be very detrimental or if the company has the power to pass on those costs to their consumers with relatively little impact on the business. Like for example, Apple, you know, they have a great brand loyalty and a company like Apple will probably be less impacted by inflation because they can just simply increase prices and their consumers are still going to purchase their products for the most part, you know, relative to another product that may be very, very substitutable like a Campbell Soup. Well, they're going to have a little bit more trouble probably increasing their products. You know, some of these food companies may increase shrinking profit margins if this inflation doesn't go away in the near term. And you're, you're actually seeing it in the, in the quarterly calls and the CEOs are referencing inflation constantly. I think if you look up how many times the, the CEOs have mentioned inflation on quarterly calls, it's, it's been a record year. It's been, it's. And you know, look, some CEOs are just going to point the finger and try to make inflation the scapegoat. And so that's happened as well. But for the most part it is having an impact on profit margins and companies are trying to figure out do we raise prices or if it's transitory, do we just absorb this in the short term? You know, and so you know, look to next year to try to see what the first earnings quarter of the year is like for these companies and how that inflation is really starting to show through in prices. You're going to see it in the grocery stores. You're going to, to see it at Christmas time when you're buying products for your, for your family members. It's definitely going to have an impact.

What about all those exciting tech startup companies? The, you know, the EV companies that are got these lofty, beautiful valuations, right, that are, as you and I know, not very supported by fundamentals. They are in fundamentals there's really two classes of stocks. If you really want to, to boil it down to a Granule or at a high level, you've got your Apples of the world, the consistent, the larger corporations that have already been at their mature phase of their economic cycle, their business life cycle, then you've got people, you got companies at the very beginning of their economic life cycle. A lot of them are in the EV space. A lot of them are these tech stocks that we've been hearing so much about during the COVID period. Zoom would be one, right, that, that are supported by lofty future projections of revenue growth and earnings growth. And when you have lofty projections on revenue and earnings growth.

How does interest rates impact those valuations?

Yeah, that's a, that's a great question. And so for, like you mentioned, more mature companies that have an earnings record, it's much easier to predict, you know, what their future revenue may look like. And you can predict it in a conservative way, and that helps you value those companies a little easier. Now with companies that are new and are growing 50%, 100% year over year, like to your point, a lot of the growth that they're experiencing in their stock price is based on projections. And so that what happens is if those projections are off even just slightly, it can have a massive impact on the valuation of that company. For example, you mentioned Zoom, and you know, I can think of other companies that benefited from this whole pandemic. Teladoc is another company online. It's like online medical advice and things like that where clients weren't, or patients weren't going directly to hospitals anymore. They were using, you know, video conferencing to talk to medical professional professionals. And, and it's very easy to think that those companies, those revenue streams are just going to boom when you're in a pandemic. And what we're seeing now is a lot of those valuations get peeled back because they were lofty expectations that we're starting to realize weren't really accurate. And it complicates things even more is when companies are not making money or, you know, not, not they're making money revenue, but they're not making money at the bottom line then, now maybe you're trying to predict when they become profitable, which could be three, four, five years, 10 years out. And all of that impacts the stock price because when interest rates rise, all stocks typically are valued. If you use a discounted cash flow model, as interest rates rise, those revenues in the future mean less today than a company like Apple who has a they're paying a dividend or, you know, AT&T, who's Paying a hefty dividend that you receive today, that that dollar is much more valuable today than a dollar in 10 years. And so when as rates rise, you know that that's going to be even more pronounced. You're going to see a lot of these high flying growth stocks have to come down, you know, in order to compensate for these increases in interest rates.

That's a great point. So your discounted cash flow analysis, which is ultimately a tool to value, is one tool to value a company. And that tool uses a stream of projected cash flows out into the future. You think, you know, think what your net cash flow is year one, year two, year three, year four, year five. And each year you're going to have different expectations. More customers, hopefully less expenses. And then the, so you're taking that cash flow in each of those periods, you're dividing it by 1 plus the discount rate. And in this case, the discount rate is the weighted average cost of capital. And the weighted average cost of capital is a function of the interest rates that the corporation has on their debts and the required rate of return from their equity investors. And as the name might imply, it's the weighted average between those two. And then that is going to be raised to the exponential power equal to the difference in years from today till how far out you're projecting the cash flows to. And so ultimately it's a formulaic issue that's happening right now. As the rates are rising, your denominator in this equation is getting higher. And if that denominator is getting higher, then the value that we're, that we're calculating as of today is also going to be lower. And if you are like Brandon and myself and the investment team here at practice cfo, you look more toward the fundamentals of a company and more toward this type of discounted cash flow analysis to make your educated portfolio design in stock picks, essentially. And if that's the case, then we should see a direct correlation between this decline in this discounted cash flow analysis and the share price.

Right? And you're starting to see that a little bit. And they call that, or they have been calling that a value rotation, and that's a rotation out of growth and into value stocks, which like you talked about those growth stocks with the hefty or lofty expectations that have revenues way into the future start to get peeled back a little bit more. And some of the big money cash flows that were going into those stocks during the easy money money policy period, which has, you know, been persistent for a while, that money is going to eventually come out and rotate into some of those dividend paying stocks which will benefit from rising interest rates based on that discounted cash flow that you were talking about?

And Brandon, you know, it's not even though the inflation, the transitory inflation that we're experiencing right now is probably higher than we expected it to be to some extent. But in general, because we're in a period still after 2008, we're still in this period where the Federal Reserve has been very transparent and they've been very calculated with what they're going to do and not only what they're doing now, but what they're going to do five years from now. So from your perspective as the portfolio manager here at Practice cfo, has that transparency allowed you to be more predictive and calculated with what you're doing for our clients, or is there still some level of unpredictability even when the Federal Reserve is being as transparent as they have been since 2008?

Yeah, I mean, so, so there's always this unknown aspect. So we can, the Fed can telegraph what they're going to do with their policies, but the unknown piece is how is that going to show through in the markets, you know, and, and so we're always anticipating or trying to, trying to predict how that's going to flow through. You can't always get it right, which is why diversification is always key in a portfolio. Right. Who knows? I mean, right now rates should be on the up and up over the next few years. But if for some reason we have a step back and some different variation of COVID comes up and we go into another recession, well, that may be delayed for quite a while. And so basically what I've tried to do is look at the Fed's policy, take information as it comes in and adjust real time. And it becomes a little bit easier when you have what we call the momentum trade right now, which is a lot of stocks that are detached from their fundamentals. And you hear a lot of people say that the market's very expensive or it's overheated, when in reality there are a lot of very good valued companies, very cheaply valued companies that are not getting as much attention. And those are the companies that, that we focused on a lot. And those tend to be value companies. Right now, value stocks are trading at some of the biggest discounts in history, even dating all the way back to 2000 during the tech bubble, which was when another huge disparity happened because everyone thought that the Internet was going to make Everything obsolete, you know, and there was a massive correction at that point in time. And so what we've done is we've stayed disciplined. We focused on the fundamentals and we've tilted our portfolios to those companies that we feel are undervalued. We've stayed relatively underweighted technology because we do think that that's a very high valued sector right now relative to the fundamentals. Relative to the fundamentals. And you know, technology is making up about, I think it's about 28% of the total S&P right now. About five or six stocks make up about 25% of the S and P right now because it's a market cap weighted index. And so it's, it's a, it's a little concerning for when I talk to investors and they think that they're diversified in an S and P index, that, that no longer really applies anymore because the lack of diversification in that index is really driven by the massive market, market cap of these companies that are trading at high valuations. For example, Tesla, right, is now in the S and P and they, they make up a good portion of it. Apple, Microsoft, Google, those companies make up a large part when you, when you aggregate them all up, Netflix as well, those companies make up a large part of the S and P index. And so if you're buying an index fund blindly, you're getting possibly more exposure to those types of stocks that you really think that you're getting exposed to. And when they do correct, if they do correct, it's going to have a large impact on your net worth.

Well said, well said. And so just to summarize, I think what, you know, in our investment policy statement, for example, right.

We always stay true to the diversified model. Right. And even when a particular sector in the market is super overheated, like the tech space is more or less right now. We're not going to pull out completely from that part. I think what Brandon is saying is that in our investment policy statement, we have ranges in each asset class and within each asset class, within each equity band.

Sector, within the equities market. And so what Brandon, to summarize, we've taken some of the gains that we've had in the tech space, which has been great in some of these momentum stocks, which has been really helpful to our portfolios over the last two, three years. And we're taking those gains and we're reallocating them now and tilting, as you said, to value stocks, which are grossly, maybe not grossly, but they're undervalued relative to their fundamental intrinsic value.

Absolutely.

And so that tilting that shifting the tactical rotation, I'll call it.

That you do in these portfolios, based on the economic cycles that we're in and based on what the Fed is doing, the interest rates and inflation, everything else in between is ultimately what leads to superior rates of return.

Adjusted for risk.

Yeah. Relative to the benchmark.

Relative to the benchmark.

And so if Your S&P 500 is a benchmark, which by the way, a lot of people use that as a benchmark, it's not diverse, it's not an international benchmark. But I'm just using that as a simple example that if you pick a 100% U.S. equity portfolio and your benchmark is the S&P 500 and the S&P is weighted 28%, the technology, but your portfolio is weighted 15%, for example. Well, when technology corrects like we think it will, when interest rates start to rise, your portfolio is going to outperform the benchmark because you have less exposure to the perceived overvalued sector. Right.

It's always hard, you know, when you're, you're talking to a client and an investor with you, an investment client, when, you know, they come with this prior experience in the market where they've been maybe in a, some type of, you know, just US Equity Indexed Fund. Right. It's only US equities and they've made 15 to 25% year over year rate of return for the last five, six years. And they've, you know, they're maybe 40 years old. They've, you know, that's virtually the extent of their investment time frame altogether. That's their limited experience in the market. And they come with these lofty expectations. And you know, we're telling them about diversification and the portfolio allocation that were, that we were prescribed, given their risk tolerance levels.

Right.

And they're telling, they're, they're. And to be. It's. I get it. If I were in their shoes, I'd be like, well, you're gonna give me half of. You're trying to tell me you're gonna make half. Right. And charge me to do it. And it's really. And I think that's where the hard part is and maybe something that we can help from an education standpoint today is that we're not playing the same game that this, in this example, that this person was playing for the first six years of their investment career. They're playing all offense and they're not even playing all offense in all the offensive categories, they're playing all offense in one category. And that leaves them very exposed. While they may have gotten 18 to 25% year over year returns for the last six years, when you adjust for the risk of being allocated all into one particular sector of the market, which is going to result in a rate of return that is much, much less than that. And so it's hard, you know, while it is hard to explain and for people to educate themselves to a point where they do understand, when you talk about the way that we're managing portfolios, we're playing offense and defense, Right. And to your point, right, when the market does make a correction, and this, in this example, this person has been in the, in one particular part of the market for six years doing 18, 20, they're going to have such, their volatility is going to be so much higher in that downturn than we would be then our clients would be in their diversified portfolios across all asset classes, correct?

Yeah. And I think one of the best metrics to measure that is what you call portfolio drawdown. And that's, you know, the peak of your portfolio to the trough, that's your drawdown. So if you're flying high and today you're at the peak, the highest point that your portfolio has ever been, and you're 100% equities, when there is a correction in the market, your drawdown, meaning how far your portfolio falls before it hits bottom and gets back to that peak again, that is going to be significantly higher than a diversified portfolio. So over the long run, and it really takes a long term viewpoint to really appreciate the diversified model in that way because there is going to be a larger correction on those portfolios that are say 100% equities. And you know, today with bond rates being so low, it's difficult to stick to the, to the, to the model to stay disciplined, Right. And to have to justify that to clients is, is difficult, which is why investment advisors and investment managers are struggling to do that. And some of them end up changing their allocations because they, instead of explaining it, instead of trying to stick to the discipline strategy, they, they just kind of want to give into it because that's a little bit easier to do than have to explain why you want to stay disciplined. Right. And so unfortunately that drives the momentum trade even higher.

And our goal is to, you know, have less drawdown in our portfolios because when you have less drawdown, that, that being again, your peak of your portfolio to the trough, if you if you lose less money on any correction, your time getting back to the peak is going to be much shorter. And so you know, it's not always about getting the highest returns. It's also about managing risk like you were saying earlier. And by managing risk you can reduce the losses in your portfolio which makes, makes, basically makes it so that you don't need as significant gains to get to keep your same nest egg.

Right, right, exactly. And you know, it's, it's, it's been a, it's been a wild fun run this, these last five years, six years. You know, when everyone's portfolios are going up and the hard conversations are far and few between. It's been a relatively easy period. And you know.

Anybody that studies the financial markets as much as you have, right? As much as I think that I have, you know, you understand that these short periods of euphoric results are short lived. Right. And if you don't pay attention or you, if you, if you choose to ignore the historical information that exists over from market, from the market inception, you're just leaving yourself, you're vulnerable due to your lack of greater knowledge of how the markets fluctuate and how you should be armed and prepared from a portfolio management perspective in order to take action on these down periods that will inevitably come.

You're right. You're absolutely right. And, and that kind of goes into the short term versus long term perspective. Right. And it's difficult to think that the market hasn't changed, to think that things, things aren't different right now. Right. But we do have.

Periods that we can look back on like say I said earlier, the 2000 technology bubble where these types of things happen and history tends to repeat itself. And what it all comes back to is fundamentals. And so at any given point in time, you know, growth stocks may detach from their fundamentals. That doesn't mean that we should all start recommending those stocks because at some point they will return to the fundamentals. And when it does, when those stocks return to their fundamentals, you want to be positioned in a way that you don't get wiped out essentially. And if you're just chasing the momentum trade, you, you could potentially get wiped out very quickly.

There's always, there's always what they call bag holders now the fall people that get this that have to fall on the sword unfortunately. And that's what we're trying to, essentially that's what we're trying to help, help you avoid really is, is to help prepare you with enough knowledge to Be prepared for a down period. Right. A market correction, a reversion to the mean.

And we don't know. No one knows. We. And everyone, you know, hopefully any manager that you invest, manager that you work with is going to tell you the same, that they don't have a crystal ball. We don't either. We don't know when, you know, this correction will happen, but nonetheless, we're prepared for when it does.

Absolutely. And, you know, just circling back to how we were talking about what, what, what do you define outperformance as? It's all relative to the benchmark. Right. So when the markets fall.

Of course, portfolios are going to fall across the board, depending, you know, most of the time that, that's how corrections happen. And if your portfolio can fall less than the benchmark, then that's still considered outperformance, even though you have a loss on the year. If you, your loss is 10% and the benchmark loss is 20, well, then you've outperformed the market. And so that's really what, what we're keeping in mind in the way that we construct our portfolios here. We don't just want to outperform the benchmark today. When things are good. We want to be positioned in a way that when things fall, we, we can go to our clients and say, look, we've, we've fallen significantly less than the benchmark. And so you're in a much better position then hopefully some of those people that were just chasing that momentum trade. And we've been preaching that for five years and finally it's paid off. You know, that's, that's kind of how that happens. The difficult thing is getting your clients to stick to the plan for that period of time when things aren't necessarily going as expected or as the fundamentals, you know, if you will, would say, right, absolutely.

I mean, that's the, that's always the difficult part of being an investment manager, that's for sure.

So we've talked about the interest rates, inflation. We've talked about how momentum stocks will respond, how value stocks may be in favor over the next few years as we run through this period of rising rates.

Let's talk about fixed income, because you can't have an investment conversation without talking about bonds and fixed income. And we did talk a little bit about the yield curve, right. The long end, the short end of the yield curve. But in this environment we're in, with this inflation and the expected rising rate environment that we're going to be moving into, how does Fixed income and bonds play a role not only in our portfolios now, but as we move through this period.

Yeah, that's a great question. And you know, there's definitely no shortage of articles out there on Google talking about the death of fixed income in a diversified portfolio and why it's not needed. And of course, course we don't believe in that. We do though, we do position ourselves along the yield curve. And by that I mean shorter duration bonds when we think that longer term rates are going to rise. Right. And so it's almost like a bank. Exactly, exactly. We want to be, we do not want exposure on the long end of the curve when rates start to rise. Because these 20, 25, 30 year bonds, now we were talking about how stocks can be valued using a discounted cash flow analysis. And there are other ways to value stocks. There is no other way to value a bond. It is a discounted cash flow analysis. So when the interest rates rise on the long end, no doubt about it, what's going to happen on a bond is much more predictable than a stock. Right now, whether interest rates rise or not is unpredictable.

Right.

We can make expectations and adjust accordingly, but once they start rising, long term bonds are going to fall drastically. And so we've positioned ourselves on the shorter end of the curve, meaning one to five year duration. Those bonds will be less impacted by interest rate rises. And to your point about the benefit, really the role of fixed income in a diversified portfolio today, I always like to use the example of what happened during the pandemic. Right. During the pandemic, March 23rd of 2020 last year was the bottom of the equity market as it relates to the US Equity market. So the S P bottomed out and from then that point on it started to rebound. But the drawdown from the peak to the bottom was somewhere between. Depending on the index that you look at the Dow S and P, it was about 35% for many of the major indexes. That's how far these indexes fell in a matter of weeks. Because of the pandemic. Now bonds, short term bonds specifically pulled back about a 1%. And so even though we're not looking at making a ton of money on a yield right now in a low interest rate environment, what that allows you to do in a diversified port portfolio is to simply rebalance. If you're 100% in equities, when it falls, you, you have no option to sell out of bonds and buy the dip. Right. Because now your portfolio has just crashed. It's a 100% already exposed to equities. If you have even a 20 to 30% bond allocation, when equities fall, well, your allocation gets thrown off. Now, for example, let's say, let's use the traditional 60:40 allocation as an example.

And he's 60 equities, 42 bonds.

Right. 60, 40, 60% equities, 40% bonds. And I just talked about how a lot of the major indexes fell 35%. So when that happens and the bonds only fall 1%, just as an example, well, you're no longer 6040 because your equity side of your portfolio has just fallen drastically relative to the bond side. So now you may be 5050 and rebalancing, which is what I was talking about earlier, is the process of getting back to that strategic allocation of 60:40, which is what you're intending to, that's the risk exposure you're intending to take. Now when it falls, you're no longer taking as much risk as you intend because you're, you're at a 50 50, so your risk is lower. So the way that you do that, you sell 10% of your bonds, which gets you back to 40, and you buy 10% more equity, which raises your equity level back to 60.

It also lowers your cost basis in the, on the equity side.

Absolutely.

And as the stocks rebound from their, from their trough and their low, you will benefit greatly by buying sort of, by, by doing this reallocation, this rebalancing act that we're, that he's describing here.

Absolutely.

And, and I think to, you know, what you were saying is if you're in 100% equities, there are no bonds to sell.

There's no bonds to sell.

Your portfolio is just truly down 35% in this example.

Yep. The entire portfolio falls that much.

And, you know, we're not blind to the fact that, you know, a lot of our clients are in heavily in their contribution phase.

Right.

You know, they've got, they have, their practices are thriving. They've got a lot of free cash flow to keep investing in every month, even during down periods. And so they do have the ability, if they want it to be more risky because they're in this contribution phase, to be more tilted toward equities than the 60:40 traditional model would say. But because their contributions are so high, that's the money that they have available to rebalance, they don't necessarily need as much allocated to bond to sell in and out. I think.

This is more of an exaggerated impact. When you're in retirement, you don't have as much contributions coming in. And when you're 100% in equities and it takes a dip, now what do you do? Yeah, you just. Now you have to take losses and.

Go back to work.

And go back to work.

That's what you do. Yeah. And you know, that's a really good point, is that if your contribution rate is high, your point is that you're contributing money, which is allowing you to buy dips without a selling out of those bonds. Right. And that has the same impact of buying low and selling high, which is essentially what rebalancing has. But the problem comes where. And also, I'll even add another situation in there to your point is if you're in retirement, you don't have that ability to continually contribute. And so you need to protect yourself. But also, clients will tend to reduce their contribution rates when the markets fall. It's counterintuitive for us because obviously you want to buy more when stocks decrease. That's your opportunity to buy at a cheaper price. So go ahead and put your money to work. But for a client that maybe not maybe doesn't have as much experience in the investment arena, it's very, very difficult for them to wrap their head around this idea of, hey, I just lost 20% of my portfolio. I'm going to continue to throw money into this portfolio and wait for the rebound. You know, human nature and human behavior and human biases make that very difficult. So I say that just to say, you know, we all have a plan until, you know, it's kind of like until something goes wrong.

I read a really cool article, the Wall Street Journal, about investment fund managers and investment consumer investors as well even. And traditionally, historically, investment fund managers are really great at picking the time to buy equities.

But they're pretty historically terrible at choosing when to sell.

Yeah.

And to Brandon's point, you know, likely a lot of it' driven by their clients and their desire from a psychological standpoint to panic sell. Right. Which leads to these poor decisions to sell relative to the great decisions on when to buy.

Absolutely. And right now you're having the retail investor have a much larger impact on the overall market than what they've had historically. You got Robinhood, you've got all of these different apps that make it very easy to trade and buy stocks. And unfortunately, it's the big institutional investors that have that ability to maintain the discipline we're talking about. And by institutional investors, I'm talking about large investment firms, big banks. They're going to act the way that we're talking about in a disciplined manner, it's going to be the retail investors that sell everything. And so the larger proportion of stocks held by retail investors relative to the institutional investors, the bigger swing in volatility you're likely going to experience when that selling happens because the institutions, again, are going to remain disciplined and act, you know, in a way that is rational for investment decision making, whereas a retail investor is possibly going to panic sell. And if that happens, you're going to see a big reversal from the momentum trade. It's going to be in the opposite direction when, when that does happen.

And just into, like you said, the, the magnitude of that change is greater now that the retail investor holds a more significant portion of the market share.

Absolutely.

Well, Brandon, I mean, this has been a such an awesome episode. It's definitely not going to be the last one that we have, Brandon on the show. I mean, luckily he's just right next door to me, so I get to talk to this guy all the time. It's so much fun. Is there anything else that you feel is important for our listeners today?

You know, I think all I can say is just keep an eye out, ear out for the market, you know, follow the data. Of course, the Fed is giving us a lay of the land, being kind of being transparent as to what they're going to do. But at any given time, things can change so quickly because new data is coming in. You've got, you know, lagging data, you've got leading indicators and you're just trying to assess everything. And so keep that fluid communication with your advisors. And don't necessarily just think that because it's this way today that opinions aren't going to change even next week, month or a year down the road based on what we're seeing coming in.

Thanks again, Brandon, for being on the show today.

Thanks for having me.

See you, buddy.