A Lesson from Tesla Being Left Out

s alongside with the sustainability of the company’s returns also could play a role.

Indexes aren’t everything

So apparently, maybe that’s it as well. But I think it’s just interesting. And, and here, I think this is instructive, you know, a lot of times when people hear what we teach about investing, they hear, “Oh, just buy index funds, right. Index portfolio.” And the reality of it is you can have problems with indexing because what happens when companies get added to an index, their price goes up before it gets added to the index. It’s you know, so in effect, because everybody knows that every index fund is going to have to buy that stock and they’re going to drive up the demand for the stock.

Then what happens is people go, Oh, well, you know, they’re going to be a lot of buyers for this stock. They buy in anticipation of the company being added to the index. And in this particular case, it’s interesting because it went up, like I just said, yeah, it went up. But the problem was when it didn’t come to fruition, it took a drop of about 21%. And yeah, so that’s a, it’s a huge, huge drop, but that’s, you know, that’s what happens. And on the other side, when you have an index and the stock is removed from the index, you have an issue.

In fact, it’s probably a good time to share this one piece of data that I was talking to a client about this week. Like, as he was just talking about indexing of an investment portfolio and I made the comment, as you know, you often hear me say that I index large US stocks. That’s a decent place to index because you know, it’s okay. You don’t have a lot of trading. You don’t have a lot of change in that particular area. And we minimize the bigger growth companies in portfolio anyway, because you know, the long term expected return of the S&P 500 or growth companies in general would be lower long term expected return simply because they’re really big, really established companies.

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Value and growth

And they sell for a high price compared to earnings and book value. So they don’t have as much room to grow. Whereas value stocks, you know, almost like 95%, 96% of the time in 20-year periods, value outperforms growth. So we would overemphasize value small about 81% of the time outperforms big companies. And when you put these things together, the overall risk of the portfolio can come down because you’re, you’re investing in a lot of different really dissimilar market segments.

Well, it was interesting because I didn’t, I wasn’t sure. So I just decided to go out and, and do some research this week. I went and looked at the, I just went and pulled up a big index or Vanguard and they have a value index fund. And I compared it to a value asset class fund that I would use that I use for, for our 401(k) plan.

And I said, okay, so what’s the difference price to book on what price of the company’s share selling for compared to book value, which is assets minus liabilities. So the lower that number is the more potential to grow. So you want a lower price compared to book value because the book value is the assets of the company. And you can give you more potential to grow over that book value. If the number that you’re actually paying for the stock is closer to it. I mean, obviously it’s more on sale and it makes sense. It just makes sense. Yeah, that’s right. So if you look at the Vanguard value index, a $1.84 was the Vanguard value index, $1.80 for the asset class, a fund that’s just tracking the asset class diligently, holding the bottom. For those of you that are nerds that want to know, we look at holding the bottom 20% of all companies in terms of price to book. That’s what we define as value. Okay. Bottom 20%. And it’s $1.28. So that’s a difference of 43.75%. In other words, the Vanguard fund is selling for almost 44% higher than the asset class.

The way I want to hold it for small companies, their Vanguard small cap index is selling for 51% higher. If you look at international large, you’re looking at 61%—61% difference between the Vanguard international value fund. Now that’s not an index fund. It’s actively managed, but they don’t have an index that actually tracks that. But it’s 61% higher. And what really blew me away because this is an area that I want to hold more in because I want to have as much dissimilar price meant.

Diversification

I want diversification if I’m holding big international companies. It’s not as good of a diversifier because big international companies move in concert with big US companies, like think of it this way: Nissan is after the same customers that Ford is after, right? So we want to hold small companies, smaller companies that wouldn’t necessarily compete with us conglomerates internationally, small value, 92% difference, 92% higher, which was mind blowing to me that the Vanguard fund was selling for that much more.

So in essence, when people say, “well, Paul, you don’t, you’re just talking about, you know, don’t stock pick don’t market time, just buy an index fund.” And I’m like, “well, that’s problematic because they’re overweighting big companies.” Yep. What was the actual price to book on the international small value between those two? So yeah, the actual price to book the Vanguard fund was $1.19. The asset class fund was $0.62. Okay. So see if this works for you and you know, it’s not as clean as say a dozen eggs, right.

Evan Barnard: But let’s say you’re in the store looking for a dozen eggs and they’re all the same grade. So, you know, do I want to pay $1.19 a dozen or do I want to pay $1.62 cents? It doesn’t, you know what I mean? It’s just, I mean, we talk about some of these metrics and granted an asset class fund is way more diversified and has a lot of other advantages.

But I think sometimes you, you kind of look at, Oh, well, this is a cheaper fund. Yeah. But you’re paying $1.19 for earnings versus 62 cents for earnings or book value.

Paul Winkler: Well, you know, and it’s not exactly the same as you well know, but you know, you could use that to help people understand the concept because you’re owning different stocks. So it’s a little bit of apples to oranges, but you’re in essence, what you’re doing is you’re buying companies that have 96% of the time value and have a higher expected return. So it would make sense to me to be a little bit more value and pay as little as you can for that value. Yeah. Yeah, exactly. So make sure that you’re way down on that end more value, more potential.

And it’s just simple, you know, we think about it this way, a company that is more value-oriented is more value-oriented for a reason. It’s not because it’s necessarily cheaper, there’s a higher risk involved in it. But the interesting thing is is you mitigate a lot of that risk. You can spread that risk by owning thousands of companies. I mean, literally thousands of companies in a value portfolio. And, you know, frankly, some of those companies are gonna fail, but some of them are going to succeed phenomenally and they’re going to, you know, literally come back and they have huge potential to grow.

The beauty of mixing your portfolio

And that’s the idea that they have to pay more to use your money. Now the beauty of mixing a portfolio this way is that by doing this, we reduce the risks because we have so many companies, but we combine it with other areas in the market. So I want as much dissimilar or dissimilarities as I can get. So if I’m owning a bunch of companies in one mutual fund that are selling for $1.20, and then I got another fund selling for $1.19 or something like that. Well, I, you know, I’ve lost a similar, I want those two numbers as far apart as I can.

And that’s what we’re getting right now. You have the S&P 500 sitting at $2.93 cents. So it would be really cool to have something in there selling for 62 cents. For sure. You see what I mean? So, I think it’s a, it’s a hugely valid point to be made that, you know, that’s what’s going on. And that’s the issue between indexing a portfolio versus just going and asset class approach. Right now, it’s just interesting because people that have been in these big growth companies and felt bulletproof for so long are starting to see, Oh, there’s volatility here, I didn’t know.

Right. What the next couple of weeks and next couple of months will bring us, we don’t know, but this is why it’s so critical to diversify.

You are listening to the Investor Coaching Show. Paul Winkler, along with Evan Barnard and Ira Work.

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