More than a decade ago, GMO strategist James Montier published a paper predicting that corporate profit margins were destined to come down from “nosebleed” levels. Fast forward to 2023, and it's clear that hasn't happened as profit margins remain far above their long-term average. On this episode of the Odd Lots podcast, Montier explains what he got wrong back in 2012, why corporate profits have remained so stubbornly high, and what this could mean for stock valuations now. He also discusses the ongoing debate over whether high corporate earnings are fueling inflation, as well as revisiting the work of economist Michael Kalecki. This transcript has been lightly edited for clarity.
Key insights from the pod:
The difficulties of forecasting — 3:47
Why did Montier think profits would go down? — 6:28
The role of government spending in profits — 10:05
Companies and monopolistic pricing — 14:36
Companies and monopsony over labor — 18:04
Minsky’s era of big government — 22:52
Is value investing still viable? — 27:11
Value in non-US markets like Japan and EM — 33:20
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Tracy: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe, you know, what's a hot topic at the moment?
Joe: (00:19)
Uh...
Tracy: (00:20)
Don't say AI.
Joe: (00:22)
I mean it is, right? But I guess… It is.
Tracy: (00:24)
Yeah, okay. AI, we're not talking about AI. We're talking about another hot button topic, which is corporate profits.
Joe: (00:31)
Yes. But it might kind of be related valuations. Stocks booming, profits booming, et cetera. Like there might be some connection.
Tracy: (00:40)
Right. Okay. That is fair. But one of the reasons everyone's talking about corporate profits at the moment is because obviously there is this new idea that maybe there is profit-led inflation, companies raising their prices a little more than they have to given input costs and things like supply and demand, and that's boosting profits. So you see it everywhere now. And one of the things that you see is corporate profits have been very, very high in recent years. Although it is true, they are starting to come down.
Joe: (01:13)
Right. And the interesting thing about high corporate profits is that there has been this expectation, has been for years, I mean, they've been very high in recent years, but I mean, I remember years ago people talk about corporate profits being high and they had to mean revert, right?
Tracy: (01:28)
Yeah.
Joe: (01:29)
And there was this assumption that they were at unsustainable levels. And people talked about this in the wake of the great financial crisis, that corporate profits were very high and it was only a matter of time before labor would take a greater share out of profit, etc. Anyway, the point is though; they've been high and they've stayed high.
Tracy: (01:45)
I'm glad you mentioned mean reversion because today we have really the perfect guest. We have someone who forecast that profits were going to mean revert, they were going to fall. This was a prognostication that was made back in the very early days of 2012. So right after the 2008 financial crisis, when everyone was sort of scratching their heads about why the recovery — the economic recovery — was slow and painful but the recovery in corporate profit margins was quite quick and dramatic, this particular guest made the forecast that eventually profits would mean revert.
However, it is now more than 10 years later. They didn't mean revert. And our guest has just published a giant mea culpa, which is something that you don't see that often in the world of financial research. So kudos to the guest for doing that. And we are going to dig in about why corporate profits remain so high.
Joe: (02:43)
I can't wait. This is a really important topic. And again, with this sort of new boom in the stock market really over the last couple of months again, we're in a bull market again with stocks last October, last fall, really negative, just absolutely on a tear lately. We’re recording this June 15th. What's driving it, how sustainable it is? These are great questions to dive into now.
Tracy: (03:06)
Yeah, and we're going to talk about valuations too because of course profits and valuations sort of naturally go together. But without further ado, I think I already gave it away, but we are speaking with James Montier. He is of course a strategist over at GMO, someone we've wanted to talk to for a very long time. So I'm glad we could finally have him on. James, thanks so much for joining Odd Lots.
James Montier: (03:26)
Thank you very much for having me guys. Really appreciate it.
Tracy: (03:29)
So I want to sound genuine here, I really applaud someone revisiting their previous work, thinking about it again and having the honesty to say “I was wrong.” So talk us through, just to begin with, how did this sort of mea culpa come about?
James: (03:47)
So I guess it really stems from just a longevity in the business when you've been in it as long as I have. You cannot possibly claim to have anything approximating a kind of good track record for forecasting. And I've written before, many, many years ago when I was back at Dresdner on the folly of forecasting, and how stupid it is to actually attempt to forecast things. And yet I still do it. And I think if one's going to do that…
Tracy: (04:14)
There’s a whole industry dedicated to doing it. So you're not the only one.
James: (04:17)
Oh, absolutely. Yeah. No, the entire financial industry seems to think it can tell the future. We make gypsies with their crystal balls look positively reasonable with our accuracy. And so I've long, long taken to the view that we really have to go back and examine our mistakes, right? There's this concept of the growth mindset that Carol Dweck wrote about years ago, and it really is that the only way of learning is to embrace your mistakes.
If you get it right, fine, you got it right. But you don't learn anything. If you get something wrong, there's the opportunity to learn something. You know, why did you get it wrong? And so for me, as I've gone over the years, and I guess I've aged and ego has died, you know, that kind of enthusiasm, exuberance of youth where you're like “yeah, I'm invincible, I'm always right.” And you're like no, look, market's just wear you down over time. You've been wrong.
And I think what's particularly fascinating to me is when you have a long-term forecast, you know, the short-term ones are just noise, right? Anybody could write tomorrow, who knows? But the long term views where, you talked about mean reversion in your intro, and mean reversion doesn't happen. That that really gets interesting to me.
And I've always kind of taken those examples of where I've been wrong 10 years after the fact and said, “okay, what on the earth did I miss?” Because for me, it's all about learning. How do I improve? I'm 52 years old this year and I'm still stupid enough to think that I can learn and maybe get better. I probably won't get better, but at least I can learn.
Joe: (05:45)
So why don't we go back, to start, why don't we go back 10 years or a little more, I guess, to your call in 2012. And at the time there's a chart in your newest white paper that's useful. It shows that at the time when you sort of first rang the alarm about corporate profits, US NIPA profit margins as a share of GNP. They're about 10%, which was well higher than anything we had seen in say the 50 years, or I guess 70 years prior. They had sort of gotten as high as 9%, but they had gotten really high at that point. So why don't we start there, talk about the conditions that had gotten us in 2012 to an extraordinary high level of corporate profit margins.
James: (06:28)
Sure. So the, the framework I tend to use to understand these things is something called the Kalecki equation.
Joe: (06:34)
Which many of our many Odd Lots listeners, we did a full episode on Kalecki…
Tracy: (06:40)
Kalecki tribute!
Joe: (06:42)
Yeah, so this is home turf for Odd Lots listeners, but yes, keep going.
James: (06:46)
Exactly, yeah. Good old Jan [Toporowski] did all the hard work for me. And I was fortunate enough when I was at university all those years ago to have someone who actually taught this stuff and arrogant enough at the time to ignore it. Back then I was a full believer in rational expectations and I was a mathematical economist and, you know, the beauty of rational expectations was really awesome to me.
And then I realized that as I began my career in finance, that actually, that was just a terrible, terrible framework for thinking. And I fell back on these tools that I'd been taught, that I'd kind of thrown out when I was being taught them. In fact, I saw my old lecturer a good few years ago — sadly, at a funeral — and had to apologize to him for my extreme arrogance when I was a student and tell him that the stuff he'd actually taught me was the only stuff I actually used these days.
And I used this equation to kind of frame the world and try and understand profits. And it comes down to this view that profits can really be decomposed from a macro point of view. The beauty of a macro framework is it imposes conditions that tend to get missed when you are dealing with kind of micro topics. So often you'll hear people say “oh, now profit margins are high because they crushed their suppliers.” Well, the problem is from an aggregate point of view, that doesn't make any sense, right? It might be true for that one individual company, but it can't be true in aggregate because...
Joe: (08:06)
The suppliers have profits too?
James: (08:07)
They’re also companies, right? Yeah, exactly. They get their inputs… so everybody's output is somebody else's input kind of thing, right? So you can't get higher profits by squishing in aggregate, by squishing your suppliers, because they just end up with lower profits. So when you take a macro lens, it gives you a kind of framework that is coherent and consistent, and that's a really powerful style.
So the Kalecki equation says: Hey, look, there's a few drivers of profits, there's net investment. If you go out and you buy stuff that's going to add to productive capacity, that's going to be good for profits. It makes sense. As a corporate, you are investing in your future, but you are providing profits to somebody else. Again, we get that kind of no firm can bootstrap itself out of that situation, but it does in aggregate create profits.
Dividends are another source of profits. Now, it sounds weird because we always think about dividends being paid out of profits, but dividends of course are an income flow to a household somewhere. And ultimately they are therefore a form of spending or potential spending.
Then you get the kind of negatives that drag on profits. So if households choose to save, that's obviously a drag. You know, they're not spending all of their income, they're saving, that's going to drag profits down. If governments are saving -- and that turns out to be the opposite of what governments do — but if governments were saving, that too would be a drag. And if the foreign sector is saving, that too drags down profits.
And so when I was looking back in 2012, we had pretty big fiscal deficits. Investment had fallen dramatically and effectively the government deficits had had expanded to fill some of that gap. And I foolishly made the forecast that it was really the government deficits that were going to have to come down. And that was going to be the macro driver of the profit margin mean reversion that we kind of all expected.
Tracy: (10:05)
So just on that note, why did you think that government spending good would come down? Because nowadays, we've had, you know, successive years of the US deficit getting bigger and bigger and bigger, and it's almost taken for granted at this point that it's just going to keep growing. But why did you think that spending would actually reduce back in 2012?
James: (10:28)
So I think it was, it was a product of two things. So I was standing there in 2012 looking at the fiscal deficit and we're, you know, post-GFC. And during the GFC, of course, the fiscal deficit exploded to levels that frankly we hadn't ever seen before, which are now dwarfed by what we experienced in Covid, but back then were really exceptional. And it was that kind of extremely high level of fiscal deficit over the post GFC or the GFC and it's kind of hangover, if you like.
That really had me thinking, it has to come down, right? Governments can't continue spending at this rate. And that was undoubtedly the thing I got wrong because I'd simply never seen, at least in the US, fiscal deficits of such magnitude for such a period of time. I should, of course, have learned from my experiences with regard to Japan, where they'd already been running very large fiscal deficits. But at that time I hadn't really figured out the kind of secular stagnation and the kind of, the US turning Japanese was going to be the road path.
It took me a little bit longer. I began to write about that towards the end of 2012 actually. I began to figure out that actually that was probably a more likely template. I should have actually listed to my old colleague Albert Edwards from Dresdner. He'd been telling me this for years, the US was turning Japanese. And I was like,” yeah, whatever.” It was great line and it's the song by The Vapors, it's all cool. But I kind of just ignored him and I really shouldn't have done, because it turns out he was spot on.
Joe: (12:17)
As we start to move over the course of that next decade, we didn't see the big contraction in the deficit as many people expected. Then of course, with Covid, deficits blew out again and significantly wider. You know, 2012 was obviously a great time in retrospect to buy stocks. And if you had just bought the sort of broad stock market in the US in 2012 and held to today, you would've done quite well. If we decompose the returns over that last 10 or 11 years, how much can we attribute to corporate profitability from the from those years to those stock returns?
James: (12:53)
So yeah, this is a really good way of framing it. And I think the way I tend to look at it, I don't have the decomp right to hand. I have done it before, actually looking at the kind of drivers. But what I've found is by far and away, the most important factor turned out to be valuation rather than profits. Profits were good, you know, they stayed high, but they did come down compared to the kind of absolute peak that we reached in 2012.
So profit margins and that kind of new levels of corporate profitability, although they didn't mean revert, they didn't continue to go up. And therefore the key driver of the performance that we've witnessed is actually being valuation. And that I think is, as ever, here's the prognostication for you: a cause for concern, right?
As a value-based investor, when I see a market that is essentially being driven by multiple expansion, that makes me kind of nervous. And so, the fact that margins didn't come down, but they didn't go up from 2012, they actually kind of, they came down a little bit and they've stayed over that decade higher than they were historically, but they didn't rise from 2012, on average. That, I think, tells you that the valuations have been a massive part of this problem.
Tracy: (14:06)
Just setting aside valuations for a second, I mean, if we look at some of the fundamentals in the macro economy that might have boosted profits, one of the things in your equation is dividends, as you've laid out previously. And I think there are people out there who would argue that companies have gotten bigger, they've gotten more pricing power, maybe with monopolistic tendencies. Could that be genuinely boosting profitability?
James: (14:36)
It's really fascinating. I think that the increase in dividends is certainly a noteworthy feature, right? Dividends in the last decade have indeed been significantly higher than they were over most of history. The causes of that I think are also interesting. To me, the fact that dividends have increased really has to be combined with what happened to investment. Because I think of investment and dividends combined as a corporate payout decision, right? You can either invest or you can pay dividends.
At a very crude level, those are your two options. And what we've seen over the last decade compared to let's say the 1950s onwards, investment roughly halved and dividends roughly doubled. And so you saw this switch in payout from a world in which corporates wanted to invest to a world in which corporates chose to distribute. Now, to what extent that is driven by increasing concentration and monopolistic power, I think is an open question. And it's certainly one that I intend to return to. I did some work internally, which I haven't published yet, but it's the next one…
Tracy: (15:45)
Oh — sneak preview!
James: (15:47)
Yeah, exactly. I've written like three papers that are now in the works. There's one more after that, which is going to be the one on monopoly, I think. And what I showed was monopoly can redistribute profits between corporates but doesn't actually raise the absolute level of profits terribly much. Because what tends to happen is there are other offsetting factors. So I think the shift in the corporate payout policy is probably a function of monopoly, but it's not hugely surprising to me that when I combine investment and dividends and compare them over history, they haven't really, as a pair, driven this expansion of margins that we've seen.
And so that fits very nicely with the work I've done, which again, actually follows from Kalecki. He's such an amazing man and so important. And yet so few people know of him. Thank goodness the Odd Lots listeners are a different breed. But you know, you walk around and they're like, "”why are you quoting some long dead Polish economist?” And even worse from an American point of view, he was associated with Marx. It's like, “oh no, the end of the world is nigh!” Yeah, he talked to Rosa Luxemburg, this kind of thing. But he did a whole load of work on what he called the monopoly power. And it's using some of his insights that I can now demonstrate in a very simple little model that actually, monopolies do not raise the aggregate level of profits.
Joe: (17:15)
Well, let me ask you another question. And it's sort of, it's another thing that I remember. We — and by “we” I mean people who were blogging 10 years ago and trying to figure this stuff out, but another story that people told and maybe tell is that, okay, you see these profit margins at extremely high levels and that it represents some tilting of the balance between capital and labor. That labor share of GDP has declined or unionization or labor bargaining power has weakened steadily over the years. And you could put two lines on a chart and unions are going down and profit margins are going up. Is there a zero sum-ness in this in terms of how much money accrues to corporate profits versus, say, how much workers can get?
James: (18:04)
Yeah, absolutely. There is, and this was really what Kalecki again was talking about with his monopoly power theory, right? He was talking about exactly this issue, the distribution of the economic pie, if you like. He wrote a wonderful paper on the political aspects of full employment all about why corporates don't actually want full employment, despite the fact that it would seem like a good idea because obviously the economy would be booming, everybody would be spending, it would be tremendous.
But actually, his argument was that corporates would really not like that because it would give — exactly the point you raised there — labor too much bargaining power. And I think one of the things that people have got wrong in the whole kind of inflation story that we've heard over the last few years is the kind of permanence, and that whole team transitory versus team permanent and all this kind of thing.
To me, the big thing that really drives all of this is exactly the dynamic you're talking about, which is: do you have the conditions for a wage price spiral? And I have been unable to see any evidence of really significant prolonged recapturing of labor's bargaining power. I think that's absolutely true. This whole dynamic is really fascinating and a massively integral to understanding what we are going through, what we've been through and — [I’m] potentially in danger of forecasting here — where we will be going, right?
But to me that distribution between labor and capital, is really important. And it's tied in with monopoly. It's tied in with these kinds of issues. We're talking about the profit margins. But the really nice thing about the Kalecki equation is that it sits above all of that and it frames it all. So I've described it as like, Lord of the Rings. I'm a nerd. I love Lord of the Rings and the Kalecki equation is kind of the one ring, right? It can bring all the others and bind them in the darkness.
And so having that overarching framework is really useful because it allows us to understand what's been going on with profits, and therefore think about what may happen with them in the future. And what you have really is, if you'd seen a huge amount of corporate power relative to labor, normally that would lead to wage suppression, which indeed we have seen: wages have simply not kept up with productivity. And here I go being wrong again. In 2018, I wrote a note called Late Cycle Lament, and here we are still in a late cycle.
I used some work by another very, very insightful economist, Lance Taylor, who sadly died a couple of years ago now. He showed how we could look at wage repression and the corporates had effectively been holding wages down relative to productivity. Which I thought was a very interesting take on the kind of monopoly theme. Because it was, to me, less about monopoly power and the way we normally think about it and the way that perhaps is more associated with the greedflation story that we've heard more recently, which is corporates using their pricing power, but much more about what one would call monopsony.
Joe: (21:09)
Right.
James: (21:10)
It was more like you had a single buyer rather than a single seller of a product. In this case, the corporates were acting like a single buyer of labor, and it had squashed labor down. Now, it doesn't actually explain why over the last decade we've had high profit margins because had they been squishing labor down, I would've expected household savings to have to decline.
But by freak of accident in the sample that I looked at, it turned out that household savings had been exactly the same. Now, some of that is driven by Covid because obviously there's a huge spike in household savings during Covid. But some of it is not quite adequately represented by the average, the floor of averages, if you like. But in between these two samples at least — the 1950s to 2012, and then 2012 and afterwards — we know that household savings haven't been the big engine, albeit by happenstance, I don't think. I wouldn't draw any conclusion by their equality in those two samples. I think they've been driven by some pretty unusual things, but we know they're not the cause of the big surge in margins that we saw.
Tracy: (22:16)
Yeah, I remember monopsony was a big topic at, I think it was the 2018 Jackson Hole and Kalecki to some extent as well. It makes me kind of wonder whether they're going to talk about profit-led inflation this year. But anyway, setting aside Kalecki and monopolies, which we've been talking a lot about, can we talk a little bit more about just big government spending because of course there was another very famous economist who talked about the potential for this sort of big government moment, are we there?
James: (22:52)
Absolutely. I think we are there, and you quite rightly alluded to Minsky who, interestingly, he was a follower of Kalecki. And so there is a lovely kind of intellectual heritage following through these guys. Minsky was absolutely a proponent of the financial instability hypothesis, which we all know and love. But also, he was a big proponent of the need for big government and he framed big government as really more like a job guarantee scheme, which is not what we've seen, but we have, as far as at least the data suggests, had an era where government spending has been considerably higher than anything we've seen before.
And so, yeah, Minsky wrote a book called Can It Happen Again? And he was referring to the Great Depression. And that book is really all about making sure it doesn't happen again. And one of his takeaways was that in the event of a private sector shutdown as there was in the Great Depression, the only thing that can happen to offset that has to be government spending. And I think with the GFC, with Covid, we have seen governments do exactly that. They really — and in Japan's case for a very long time — we've seen governments do that. And so we've seen this era of big government actually, and big government spending actually arrive. How long it lasts, as I confess to the paper, I have no idea. But it's certainly there right now.
Joe: (24:19)
Well, you know, so much government spending in the US is entitlement spending and it seems like there's no imminent prospect of some meaningful change in social security payouts or in the change of trajectory, no imminent prospects of the change of trajectory of healthcare spending. We have a society that's getting older, it's doubtful that there's going to be any change in defense spending.
There's not even that much appetite on the discretionary side, nor does it seem that big. Something I've wondered about is, does this provide a sort of cushion of stability, a sort of like cushion of sort of macro stability and perhaps profit stability? That there is this huge chunk of spending. It's every year and guaranteed, and there's almost no political appetite to make it go down?
James: (25:08)
Yeah, absolutely, right? You'll get some conservatives who tear their hair out at prospect of government intervention and any number of them are interestingly fellow value investors. And I obviously missed the Kool-Aid on that one, but they all get really hot under the collar about government spending. As an old Leftie, I tend not to.
But yeah, I think you're right. Big government is inherently a kind of prerequisite for stabilizing an inherently unstable system. And that's exactly what Minsky was alluding to, right? He said that big government must be big enough to ensure that swings in private investment lead to sufficient offsetting swings in government deficits so that profits are stabilized. And that was his guiding concept, right? Now he thought you could best do that with a job guarantee. Well, you know, that’s been talked about and universal basic income and all these other concepts get talked about, but the reality is it's been implemented in a very different way, but it's there. And as you say, it's kind of hard to imagine, given the state of politics, it's kind of hard to imagine that's going to change anytime soon.
Tracy: (26:33)
You mentioned value investing just there, and of course we would be very remiss if we didn't ask you about what's going on there because we've seen these headlines for a while now. “The death of value investing.” The idea that everything nowadays seems to be fueled by momentum. I wrote a story just recently about how all the most terrible stocks and assets, all the things that people were saying were overvalued for a long time — stuff like Tesla, Netflix, some long duration bonds — those are all surging once again. Is there any value to be found in value investing? nowadays?
James: (27:11)
I really hope so. If there isn't, then then I better retire and GMO along with me. I think there is, because we know that the markets, Howard Marks always puts it really well, right? The markets swing on pendulums from euphoria to despair and back again. You know, go back a year and we had what my colleague Ben Inker delightfully called “JOMO.” So rather than the FOMO — the fear of missing out — we had the joy of missing out. Finally, you know, all the crap that had gone up didn't. And some of the stuff we owned actually went up and it was like “yes.”
And now we're back to the other world. And so our JOMO was very short lived. And at GMO, we have experienced any number of these horrific experiences where in the long term you can be right and in the short term, utterly wrong. And that's an incredibly painful thing. And it's why value investing is so hard, because you can sit there, you can do your work, you can kind of gather your intrinsic value, you know what fair value if you like, should be. And then Mr. Market turns up and decides, yeah, he's in a manic phase today, and so he ignores any kind of anchor or valuation right up until he doesn't, and suddenly he wakes up one day and decides he does. And the problem is you never know when that is.
And that kind of, that's the classic uncertainty of… well, it's what makes being a value investor so hard, right? If that wasn't there, I guess everyone would be a value investor and value presumably wouldn't work. But because there is this collective madness of crowds experience, Joe, you mentioned AI right at the start, you know? Will that be the next bubble? God only knows, right? It's got all the hallmarks of it. It's a technological innovation that gets everybody excited. Historically, that's kind of classic bubble breeding territory. It could be. And… Sorry, go ahead.
Joe: (29:14)
Well, no, just to play devil's advocate for a second, I mean, obviously the 2010s were this extraordinary decade for Big Tech, and, you know, Big Tech is rallying again lately, this handful of Big Tech. But the other thing about that decade is it's not just that those stocks did well, those companies did really well, and Amazon and Google and all these names were far more profitable in 2019 than I think people in 2012 would've guessed about where they'd be in 2019. I mean, they really did do extraordinarily well from like a business and profit standpoint. So I mean, setting aside, you know, valuations and multiples, the companies did do really well and captured a huge share of that overall corporate profits. Right?
James: (30:00)
Absolutely.
Joe: (30:03)
And so there's something [there], I don't know, when you look now at once again, people piling back into these names and QQQ not really that far off from its high, is there some reason why that can't be sustainable? And I guess, you know, if we already sort of stipulate too that this one source of profits, which is government deficits, does not seem to be going away. What changes this current environment?
James: (30:30)
Yeah. I think the thing with those kinds of companies is, we go back to that kind of beauty of the macro framework, they succeeded by eating everybody else's lunch. They turned from, I guess, the weedy little kid to the huge jock who was wandering around thumping the weedy kid and saying “I'm going to have your lunch money and your dinner money and your breakfast money as well.” And that's how they won, right?
They did exceptionally well and far better than — I think you're right — pretty much anyone would have said. The problem is, I think, that at some point you run out of people to bully. You know, the playground empties, everybody graduates, and what happens then? Well, your jock-bully is suddenly not quite so comfortable anymore.
And when you then put a kind of continued growth multiple on those kinds of guys, that gets hard. You know, it's not hard to grow fast when you're really small. It's really hard to grow fast when you are really big. And that's, I think, always the challenge. It's that kind of growth, they call them growth torpedoes, right? Where people's expectations are so extreme and the pricing of some of those stocks, not all of them by any means, but some of them is really extreme in terms of their implied growth for the future.
You kind of have to scratch your head and go, where the hell is that coming from? You know, how much more advertising can Alphabet really take over? How many more businesses can Amazon completely disrupt? And maybe they will, right? There will be winners and maybe those guys are the ones that will win. But the market is pricing it as if that is an absolute certainty. And that always kind of, anytime anyone ever that sure about anything, I tend to kind of get a little nervous because I'm not even sure I exist, let alone anything else. You know, for all I know I could be a brain in a jar, in which case I clearly lack imagination.
Tracy: (32:24)
This is getting very existential.
James: (32:26)
Yeah, right? But it's possible, right? And that to me, that absolute certainty is concerning. I think it was Voltaire who said, “To live in doubt is unpleasant, to live in certainty is absurd.” And that's always been my byline, right?
Tracy: (32:42)
So we've been very focused on the US market and the idea of American stocks being priced to perfection. But of course America is not the only market out there. And I was reading just before we came on actually, actually Joe, did you know this more than half of Japanese companies trade below book value? Have you heard that?
Joe: (33:00)
I didn't know that. I knew that Japanese stocks, I think they've been doing well. But I didn't know that.
Tracy: (33:03)
Yeah. So they were undervalued for a long time and then this year there suddenly seems to be renewed interest. But James, to your point about value investing, is the implication here that maybe investors should be looking to non-US markets?
James: (33:20)
Yeah, absolutely. I think there's a couple of things people can do. Within the US, if you’ve got to be in the US, there is some stuff that's cheap, right? The really deep value, the stuff that nobody wants to own does actually look really compellingly cheap to us. But outside of the US I think you can do so much better. I mean, if you look at, funny you should mention Japan, you're absolutely right about half of stocks below book. So here’s another plug; not the next note, but the note after that is on Japan and its profitability.
Joe: (33:45)
Oh, good.
James: (33:46)
One day I'll get round to publishing. They're all just waiting to be published now. And in there, I did a similar analysis to the one that we've talked about today for Japan, I won't dwell on that now, but the striking chart to me was when I looked at EV to Ebitda in the US versus Japan. So in the US you've got the US market trading on nearly 14 times EV to Ebitda. In Japan, the market is trading on like five times EV to Ebitda.
So Japan is certainly, with any kind of measure that looks at anything that concerns balance sheet-based analysis, Japan looks compelling. It too has had a profitability surge. Now, not to the same levels as the US, but it has had this ongoing profitability surge. But I think interestingly in Japan's case, it actually looks kind of very sustainable because it has a lot to do with de-leveraging and therefore kind of more cash flow flowing through to the bottom line. You've basically had this long battle between the holders of debt and the holders of equity. And the holders of debt have been taking a lot of Japan's cashflow. Now that Japan has delevered, which has been going on since the early 1990s, you've now got a situation where that cashflow is flowing through to the bottom line. And Japan therefore looks like it is a market where we have kind of increased profitability and low valuations. You know, what's not to like there?
And if you're a really brave value investor, go play an EM. I mean, nobody, nobody in their right mind wants to talk about EM. And we know that social pain, the pain of being excluded, being ostracized and ridiculed is felt in the brain in the same parts as real physical pain. So being a value investor is like having your arm broken on a regular basis, which isn’t fun, right? It's why most people don't do it, but EM looks amazingly cheap. Like the bad news is so in the price. And so I think there really are some amazing opportunities around the world.
Joe: (35:45)
When you publish your notes on these, can you provide the Kalecki equations for these? Because I always see it for the US and I never see people make them for Japan or Brazil.
James: (35:56)
Absolutely. Yeah. When I do…
Joe: (35:59)
Just as a personal request, if I can put in a request for the DJ, please make a series of charts showing these same things for other countries. Because I only ever see people make it for the US, really.
James: (36:11)
Done. I promise you. When the Japan note comes out there, it'll be there, right up front for you.
Tracy: (36:17)
We'll have to collate them all and publish them on the Odd Lots website. I just saw a headline go by that says “Pakistan Gets No Bids for 15, 20, and 30-year Bonds.” So, you know, to James' point: if you want to run away from the herd, it does seem like parts of EM are the place to go at the moment. James, we're going to have to leave it there. But we really appreciate you coming on. That was so much fun.
James: (36:42)
Oh, my pleasure. Thank you so much for having me guys. It's been a blast.
Joe: (36:45)
That was a blast, James. We'll have to have you back. Thank you so much,
Tracy: (37:01)
Joe. I love having self-described old lefties employed at large asset managers on the show, it's so much fun.
Joe: (37:09)
They are some of my favorite people to talk to. That was really good. I mean, I really enjoyed it. I think we've both been reading James's stuff for several years and hearing him sort of like put together his way of thinking, some of the mistakes [he’s made], the opportunities right now just look really good.
Tracy: (37:24)
The introspection I think is really important because you do see people make these big calls and kind of gloss over mistakes they've made in the past. And really, it's not about, you know, schadenfreude or pointing fingers at people who got stuff wrong. It's about trying to understand the way we were thinking of things in 2012 and what happened differently to make those theses not applicable.
Joe: (37:52)
I do think that almost everyone in every dimension assumes some level of mean reversion, right? From everything, right? Tech versus value deficits, labor versus capital, etc. So you see something at the high end of some range of a chart. You make some chart on Bloomberg or you make some chart on FRED and the numbers at the top, and you say, “okay, it's going to go down.” And so looking back, it's like, “well, why didn't it go down? Why did it go up even further?” It’s really interesting. And it sort of, as he puts it, makes you humble about your guess for the next 10 years or whatever.
Tracy: (38:25)
Yeah. Also James' point about maybe we are in the era of big government spending, I mean, that's a big point to make, but beyond that the idea that that might not necessarily be good for shareholder returns, is really counterintuitive to the way a lot of people think about it. Because one of the big criticisms of government spending is like “oh, you're just, you know, inflating corporate profit margins” and this is why there are some investors out there who like to talk about, you know, big infrastructure programs and things like that. But James made the point that that might not actually lead to a good return.
Joe: (39:04)
Right. I like the knock on other value investors. And this is like, don't you know where our profits are coming from? Don't you know what drives corporate profitability? And yeah, that was great stuff.
Tracy: (39:14)
All right. Shall we leave it there?
Joe: (39:16)
Let's leave it there.