Episode 8 – How the Smart Money Invests

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Hello, everybody. Thank you for tuning in to Market Perspectives, a Mercer Advisors podcast where we provide a data-driven, common sense perspective on the economy, on markets, and on investing. I’m your host, Don Calcagni, chief investment officer at Mercer Advisors.

Today, I want to explore how the smart money invests. And in order to do so, I think the first order of business is to describe, well, who is the smart money? Well, I think by any objective definition, the smart money consists of large institutional investors.

Well, what makes them so smart? What makes their portfolios so smart, perhaps relative to other portfolios? Well, first and foremost, they have the sophistication. They have the resources to incorporate the absolute best scientific thinking available into their portfolios.

Well, what is it? What is that scientific thinking that they are incorporating into their portfolios? Well, what they’re doing is they’re incorporating Nobel Prize winning research in financial theory that has been identified over the past seven or eight decades. This is research that has won Nobel Prizes for folks like Professor Harry Markowitz, who unfortunately passed away a few weeks ago, Merton Miller, Myron Scholes, Bill Sharpe, Eugene Fama at the University of Chicago. There is a long list of Nobel Prizes that have been awarded in economic sciences over the past seven or eight decades that have significantly advanced our understanding of markets and how to optimally structure and manage portfolios for investors.

And so today, let’s just touch on, well, what is some of that science that, quote, “the smart money” is incorporating into their portfolios? First and foremost, the smart money. They are constructing highly diversified global portfolios.

The smart money isn’t engaged in market timing. They’re not engaged in sector rotation. They’re not doing anything along those lines. They’re not building highly concentrated portfolios of only a handful of stocks.

And that’s because the investment science, going all the way back to the research done by Harry Markowitz in the 1950s and followed up by research that Bill Sharpe did in the 1960s, all of that research had identified very early on that investors would be wise to build highly diversified portfolios. So the smart money is they’re typically building very diversified portfolios, global portfolios consisting of many asset classes and many hundreds, if not many thousands of company stocks and bonds in their portfolios. So that’s number 1.

What else are they doing?

For example, how to diversify within asset classes? So when we think about the building blocks of a portfolio, I’m sure you may have heard of asset classes or asset allocation. And certainly, that is critically important. That is the first step really in building a portfolio.

But the smart money goes a couple of layers deeper. Within asset classes, they don’t look at things like sectors or industries. They’re not investing just in health stocks or technology stocks. They’re looking at companies through the lens of factors.

Factors are how academics–

they are, how financial economists think about companies or stocks or bonds in a portfolio. A factor is a quantifiable, transparent characteristic, something that’s very tangible, something that we can almost put our finger on, that statistically is highly correlated to high future returns. Factors are those things that explain the differences in expected returns, which means returns going forward across different stocks.

So for example, within stocks, if you just look at the stock market as a whole, we know for a fact that not all stocks obviously have the same returns over time. And so what academics, what financial economists are looking for is they’re looking for something that explains. Well, gee, why do some companies outperform other companies over time?

Now, in the more, I’ll say, popular finance world, if you put on the television, they’re talking about things like AI or technology or whatever. Pick your sector, pick your industry. But the reality is that’s not how financial scientists think about stock returns. They’re looking at things like valuation.

What is valuation? Well, I’m sure you’ve heard of value stocks. They’re looking at things like the price of the company’s shares relative to some asset. It could be earnings. It could be what we call book equity.

Value is all about the price that you pay to have a legal claim on the future expected profits of that company. And I’m sure we’ve all heard of Warren Buffett and how successful he has been throughout his investing career. And he is often characterized as the world’s greatest value investor. And indeed, value/valuation has been an important part of Mr. Buffett’s investing strategy for many, many decades.

And so going all the way back several decades–

in fact, this research goes all the way back to the 1930s–

value/valuation has been shown to be a very powerful predictor of future expected returns. And for that reason, many institutional investors, and certainly the smart money, they are incorporating value into how they think about portfolio construction.

Now, the evidence behind value stocks is quite convincing. What we observe when we look at the data going all the way back to say, the 1920s, is that value stocks outperform growth stocks. Growth stocks, by the way, are the opposite of value stocks. Those are stocks with very high prices relative to future profits. What we find is that value stocks outperform growth stocks about 60% of the time over any 12-month period.

Now, 60% of the time is not 100% of the time. So there’s an important point here that we have to keep in mind. And the smart money knows this.

They know that value stocks will not outperform growth stocks all of the time. They know that there will be long periods of time when value stocks, perhaps, underperform growth stocks. But the smart money knows that over time, the price that you pay for an investment is probably the most important predictor of how high your return will be on that investment over time.

So the smart money focuses on doing well over time, not every time. The smart money is not trying to outperform the benchmarks or the markets every 12 months. The smart money is taking a long-term view of how to build the portfolio, how to carefully manage risks, and how to purposefully diversify that portfolio in a way that minimizes risk but maximizes returns over the long term.

So value, value is one of those factors that academics have identified as being a powerful long-term predictor of future outperformance. But it does not outperform all the time. And like I said, the smart money knows that.

So what are some other factors that perhaps the smart money is using to incorporate into their portfolios? Well, the second is this idea of profitability. And I think it logically follows, and I think most of us get this intuitively, that high-quality stocks with above average profits, above average profit growth, above average profitability relative to other stocks in the market that, hey, those stocks over long periods of time should deliver long-term outperformance to investors. And indeed, we see that in the data. We see that highly profitable stocks over time outperform less profitable stocks.

And so those are two very powerful factors that investors focus on. And indeed, back to my Mr. Buffett comparison, Warren Buffett has incorporated high-quality profitability measures, combined those with value into how he and his team have evaluated stocks for a very, very long time. So indeed, I would argue that in many ways, Warren Buffett is indeed a factor investor, and I would certainly characterize him and his team as, quote, “the smart money” when it comes to portfolio construction and portfolio management.

And so what kind of returns are we talking about? And today, I’m just going to highlight these two factors for the sake of time. But if we look at value stocks in the United States, and we go all the way back to the 1920s, what we observe is that value stocks outperformed growth stocks on average by nearly 3% per year, going all the way back to the 1920s.

That’s pretty significant. You don’t need a PhD in mathematics to see that. If you could earn an extra couple of percentage points, or even an extra three percentage points annually on part of your portfolio, that that can lead to some pretty significant wealth creation over an investor’s time horizon. So that’s pretty significant.

What about these highly profitable stocks? Over time, what we have observed is that highly profitable stocks outperform less profitable stocks by nearly four percentage points annually within the United States, going back all the way to the early 1960s. That’s the earliest date for which we have some really high-quality data to evaluate profitability for companies.

So think about that. Value stocks close to 3% annualized outperformance, again, relative to growth stocks and highly profitable stocks, almost 4% annualized outperformance relative to less profitable stocks. That is a pretty significant outperformance over those long periods of time, at least historically.

Now, when we step back and we look outside the United States, what we observe is that value stocks and highly profitable stocks also outperform outside the United States. And this is a key point that the smart money looks for. They want to see not just a significant magnitude of outperformance by a certain factor before they consider incorporating it into their portfolio.

They’re also looking to make sure that it’s pervasive, that it shows up in other markets and not just in the United States. And indeed, when we look outside the United States into developed market stocks and we look at emerging market stocks, what we see is this same pattern of outperformance persisting in those markets. And that is a great sign for investors because we know that we can build globally diversified portfolios, but we can still seek these, what we call, risk premia that outperform over long periods of time.

Now, just like with value stocks and the fact that they outperform on average more than 50% of the time, we see the same outperformance with highly profitable stocks. They tend to outperform less profitable stocks about 66% of the time over any 12-month window. But to be fair–

and I want to go back to that value stock example I gave a little while ago–

what it means is that there are times, 40% of the time, value stocks are underperforming relative to growth stocks. And that’s an important point.

Like I said, the smart money knows that, and that requires a high degree of patience. Warren Buffett once famously said that the stock market is a mechanism for transferring wealth from the impatient to the patient. And if there’s one thing that the smart money knows, it’s that they must be very patient and wait some time for these factors to pay off over time.

So the smart money is investing over time. They’re looking to do well over time. They fully expect that they’re not going to outperform every time. And that’s a key distinguishing characteristic between the smart money and, I would say, everybody else in the market.

So those are two very popular factors–

value, profitability–

that really define what it means to invest like the smart money.

Now, just to wrap it up here. Typically, at this point in the conversation is when there’s someone in the audience. And certainly, I would be that person if I was hearing this for the first time, where I would ask, gee, you highlighted some data going all the way back to the 1920s, for example. What does the more recent record show with respect to the performance of factors relative to, let’s just say, the S&P 500 or the broad market? And indeed, when we look at, for example, globally, if we were to look at the All-Country World Index, that is a global index of stocks, no cherry picking whatsoever.

And if we were to compare a factor-based version of that relative to a non-factor-based version, what we see is since 2000–

let’s just call it over the past 20, 22 years, 23 years. Since 2000, the factor-based strategy outperformed the non-factor-based strategy by about 3% annually. So very much in line with those longer-term statistics that we see when we look at the historical record. So that’s globally.

Now, what about inside the United States? The United States has, hands down, the world’s absolute most competitive financial markets. So how have these factors done inside the United States relative to the S&P 500? What we observe–

again, same timeline. Let’s go back to 2000.

So I’m showing you data that goes from 2000 through the end of 2022. So pretty recent data. And what we see is that the factor-based strategy outperforms the non-factor-based strategy here in the United States by two percentage points annually since 2000.

So even though the US market is significantly more competitive than non-US markets, what we observe is still about two percentage points annually. Think about that 2% compounded annually over time. Well, that’s quite significant. That’s quite significant.

So we’re not seeing any evidence either abroad or here in the United States, that somehow the world has changed and that factors no longer work. And indeed, we actually see lots of evidence that factors continue to work. And I think for this reason, this is why we see a factor-based approach to investing, by far being the most popular approach for, quote, “how the smart money invests.”

So that’s all for today. I hope you found our conversation helpful and insightful. If you do have any questions, please, again, feel free to reach out directly to your advisor here at Mercer Advisors, and we look forward to having you join us again next week. Thank you.

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