Full Transcript: The Excess Returns Weekly Wrap - 5/31/2026
Stocks, Casinos, and Cathedrals: Clips from Adam Parker, Robert Hagstrom, and Eric Crittenden
Jack: Welcome to the Excess Returns Weekly Wrap. I’m Jack Forehand, and I’m joined by a man who’s been dropping some incredibly deep life wisdom on LinkedIn.
Matt: What did I do on LinkedIn?
Jack: So I’m scrolling through the other day, you know, and basically, as you know, I’m not a man who wants to have too much introspection about my life here. I just want my data and I wanna move on with my life. So I’m doing—
Matt: Introspection is a lot of trouble.
Jack: It’s not my thing, so— I’m just gonna—
Matt: Put it on the record, yeah. Put it on the record. It’ll only get you into trouble. Right. Better to never introspect, plow ahead, bottle it up. Just bottle
Jack: it up. So when I go on LinkedIn, I basically just wanna see a bunch of people selling themselves with AI-generated posts, because that’s basically what it is these days. That’s the platform. So, you know, that’s what I’m getting. Em dashes are flying left and right as I scroll through all this stuff. And then I finally get to Matt Zeigler on video, and it’s scrolling through, and what it says is, “How am I complicit in creating the things I say I don’t want?”
And I’m like, “There goes my next three months,” because now I’m sure I’m that in many, many ways, and so now I’ve gotta work on myself for the rest of the summer.
Matt: Well, welcome to the world of Pema Chodron and Buddhist philosophy. And yeah, I mean, I think that took me down seven, seven hard years of life. So congratulations on finding that. Yeah. So that starts
Jack: me now, yeah. So I
Matt: wanna thank
Jack: you for that.
Matt: This is... You’re welcome. And, you know, let’s be honest here. The thought leadership thing, like whatever garbage is there on LinkedIn, we can only do our part to try to throw the biggest hand grenade we can occasionally lob— Yeah, exactly. Yeah, into that wretched algorithm, that cesspool of cold DMs from people who are like, “I wanna pitch you on my iron ore mining company. Why haven’t you responded yet?” You’re like, “Ah, why do I even bother with this?” I’m sure people were taking
Jack: it back when they saw yours compared to all that other stuff coming through.
Matt: So congratulations on that. Yeah, this is why I don’t get any impressions on there. Thank you. Good luck with your, uh— And it’s
Jack: a great question, by the way. It’s something I probably should consider a lot, so—
Matt: We all should consider that question. You know what else we should consider? Some of these great clips from this week. I’m actually really excited about this. This
Jack: is— We should, because people do not wanna see you break down me psychologically during this, so we’re gonna go ahead and get into some of the best investing clips from Excess Returns this week. We’ve got Adam Parker, we’ve got Robert Hagstrom, we’ve got Eric Crittenden. We had some really good stuff, and so let’s get into it.
Matt: I think the through lines through this week — and I know I’m surprised by this every week so I should stop being surprised by this — the through lines between the guests, some of the stuff that Adam Parker goes into with valuation stock picking, basically income statements, how you look at companies, how you think about it at the top of the market. Hagstrom on the portfolio theory side of putting stuff together. And then, and we’re gonna get into it, the whole Buffett casino versus cathedral metaphor, and then the way Crittenden breaks down what’s going on in Standpoint and how he thinks about hedgers and basically taking money from hedgers and structuring a fund around this.
Beautiful, beautiful full circle moment. This is me with the camera, the trash bags blowing in the wind, the most beautiful thing I ever seen. This is how this feels, a true American Beauty episode of Excess Returns.
Jack: It is great. So let’s start with Adam Parker. And what I love about Adam is he’s a quant, but he has very, very different takes on data. Like, he finds things that many other people aren’t able to find. And one of the things we talked about pretty early in the episode was this idea, you’ve got value investors like me shaking their fist at the market for years here, being like, “The market is not trading on fundamentals.” And Adam takes issue with that, and he’s right about it. So here’s Adam talking about that.
Adam: It’s easy to say, “Oh, the market’s not trading on fundamentals. It’s, you know, retail idiots or crypto bros,” or whatever people wanna say on the institutional side when they’re underperforming. But the truth is, it might be trading on fundamentals. It might be trading on a distribution of outcomes of 2030 fundamentals, or 2031, or something in the future.
And by the way, just actually interestingly, and this is maybe just coincidental, but the stock market S&P is up around 9% or so year to date as we’re recording this. The bottom-up estimates for this year are about 8% higher today than they were at the beginning of the year. If you look at the sector level, the sectors where the estimates are up the most year to date are tech and energy. They’re also the two best performing sectors. The sectors where the estimates are down the most are consumer discretionary, financials, and healthcare. They’re also the three worst performing sectors. So there are some things where the fundamentals have tied to performance, but I get the concept of the stocks are ahead of the fundamentals for the AI kinda data center build-out.
I mean, there’s no doubt about that. And so I think people are just trying to say, maybe unknowingly, “Hey, I’m the man. I’m gonna call that top before everyone else. I’m gonna get it right.” And I think that’s tough, tough, tough call. I mean, every day you’ll read some doomsday thing saying this is the top or whatever, but the market’s up 100% since the first time I read one of those.
Jack: So the first thing — and I think this is kind of one of the reasons we’ve talked about why people don’t understand what’s going on with the Iran war and stuff, and this is the reason — is that the market sort of sees through a lot of things to like the overall fundamentals. And Adam made the point, like the market might be trading on 2030, 2031 fundamentals, and what the hell do we know about what those are gonna look like?
I mean, with AI, those could look very, very different. You know, the market could be cheap on those levels even though it’s very expensive now. And so I just think it’s really important to think about like when you’re saying the market’s not trading on fundamentals, the market is not trading on the fundamentals of like the PE of like last year’s trailing 12-month earnings. It doesn’t care about that. It cares about what’s gonna happen in the future. And if what’s gonna happen in the future is big, which if you look at like things like the Mag Seven it was, and those companies ended up being cheap, then the market could be trading on fundamentals even if it’s expensive.
Matt: The market doesn’t care about your fundamentals. And I think this is one of those things where people want to impose all their back tests or all their knowledge or their historical mean that they pulled out of J.P. Morgan Guide to the Markets, and they’re like, “But look at this CAPE however many standard deviations above.” It’s like the market doesn’t care about this the way you do.
I go back to real estate over and over again with this thing and just try to remind myself of this. It doesn’t matter what your house is worth when you just look on Zillow. It only matters what your house is worth the day you turn to sell it or buy it. It’s when the transaction happens. The transactions happen at the margin.
And at different points in time, sort of Adam’s point here, is you have to think about who’s transacting at the margin and how are they thinking about this. Because it just might be the dominant players who are moving prices right now in response to the Iran war are looking through, are looking past it. Are like, “Well, we have to reposition this for our supply chains or our investments when we think about 2032.” And you just don’t know if those are the people buying houses in the neighborhood right now or not. And you have to remember that there are forces at play that you’re not gonna understand in your personal valuation framework.
Jack: And the other thing that was great here was the change in estimates because this kind of— Oh, yeah —is the same idea, but in the short term. He was like, “Well, the market’s up nine percent this year. Estimates are also up nine percent this year. Well, look at the sectors that have estimates up the most. They’re up the most. Look at the sectors where estimates are down the most. They’re down the most.” Like, this actually all makes sense when you look at the change in estimates that have gone on.
Matt: Yeah. Estimates and expectations. Look at both of those things, and at least you have kind of an idea about who’s moving in and out of the neighborhood or if it makes sense, if what’s going on makes sense. Adam’s framing I just think is perfect here.
Jack: And you know, you can say estimates are wrong, which they are a lot of times. But in aggregate, like directionally, they’re not that wrong. Like if estimates are all going up on a certain sector, usually you don’t find a situation where earnings are actually going down. Like directionally, estimates are usually in the right vicinity at least.
Matt: Yeah, and you should look at that and not just expect a mean reverting series or whatever else. But look at the direction, look at where they’re moving, and have an understanding if they’re chasing beyond anything that’s reasonable because that happens too. You can see the expectations creeping more and more and more and more, and at some point you might say, “This just shouldn’t be as high.” Still be careful about it. Watch. And I know we get into that in another clip with him. But it’s this awareness of always kind of looking forward and remembering that’s what markets do. They look forward.
Jack: So this next one kind of relates to that one, which is why I brought it up. We’re doing two Adam clips in a row here. But this idea that valuation, you know, many people like buying cheap stocks. And this is probably his most controversial take of the episode, but here’s Adam on that.
Adam: Valuation doesn’t work to pick stocks. I mean, I don’t know how many times you have to s— how many years you need to know that. I actually have kind of changed my view on that to the point of I just almost think it’s arrogant now if you say, “I buy a stock ‘cause it’s cheap.” You’re just saying you think the optical valuation has information in it. You see it’s cheap, but no one else with all the computer power in the world and all the people that are looking at it think it’s cheap. What the hell are you talking about? Like stocks that are cheap are cheap for a reason on average. The reason you wanna buy a stock that’s low is if the estimates are too low, not if the price to earnings is low.
It’s about like expectations versus reality, right? A lot of those stocks are cheap because expectations aren’t close to reality, which is bad. Buy low, sell high means buy where the estimates are too low and sell where the estimates are too high, not the price to earnings.
Jack: On that estimates point — that’s another thing you mentioned — this idea that the penalty for missing has become very, very severe recently relative to the reward for beating. And that in the cheap companies, that’s even worse. Those companies are getting killed, right?
Is that right?
Adam: Yeah. So maybe not everyone knows this, but about 70% of companies beat estimates. So you gotta unanchor your head from it being 50/50. And that’s either because of that thing I mentioned earlier where there’s wiggle room on the P&L, or they guide conservatively, or the estimates, the analysts aren’t what they believe or whatever it is, right?
But 70% beat. So what’s really interesting is stocks that just got more expensive over the last quarter, they have a higher probability of beating estimates. Stocks that just got cheaper have a higher probability of missing. So there’s information in the change in multiple, right? And then the probability you beat a second time, given you beat the first time, is higher than the unconditional probability.
So all of a sudden, it’s not just momentum why the stock’s up. There’s information in it, like the market’s on average correctly predicting that the company’s gonna beat estimates. And so we’re in this regime right now where the penalty for missing is way harsher than the reward for beating, but the market’s up because more companies beat than miss.
And so the wise-acre advice I give to some of my clients is just don’t own stuff that misses. You know what I mean? But it used to be you could say, “Hey, I know current conditions are kinda weak for this business, but I feel like the stock’s cheap enough and it’s down a lot, so it’s kinda discounting a recession and I believe it’ll be in better shape in two years and I’ll buy it here.” Like that was a completely reasonable thing to say in the 1990s and even the first half of this millennium. But now the market is crushing the companies that are cheap that miss because it’s saying, “Hey, there’s a serial correlation there. The probability they miss again is higher than the unconditional probability.” So I think that’s changed. Like the market’s gotten increasingly anticipatory and right on average.
Jack: So yeah, I mean, this is obviously — when you hear it — it’s arrogant to buy a stock because it’s cheap or something. It sounds controversial, but I think — and it’s interesting for me because I’m a factor investor. So one of the factors you use is value, and when you use value, you’re betting on like across a series of companies that the ones that are cheap, expectations are a little bit too low and they’re gonna come back up.
But that’s not what he’s talking about here. He’s talking about the idea of using valuation to pick individual stocks. And I think what’s really important to keep in mind if you’re going to do that is — and he made this point — the market is very, very smart. So the odds on any individual stock that you’re gonna just pick this gem because the PE is cheap and the market is completely wrong, it can happen, but it’s really, really hard.
Matt: One of my favorite things from the quant team from when I was at Merrill was when they would do the giant overview. Basically like earnings, revenue, free cash flow, betas, and momentum in those data sets, usually paired with a quality factor or something else, were some of the better looking and better testing data sets for both stock selection and whatever else.
And it was all based around this idea of what Adam’s explaining, where you have 70% of the time these companies are beating. And if they’re beating 70% of the time, you actually should follow the companies who have that positive earnings momentum or relatively stable earnings beta, or pick your cash flow or your revenue statistic of choice to follow this against.
And what that data showed very plainly was that losers keep losing until they turn the corner, and then when they do, if they turn the corner, then that’ll balance out. All of a sudden they have positive earnings or revenue or free cash flow momentum. But when it’s on the downward trajectory, if the rest of the companies are beating 70% of the time, and these are in the 30% of the losers, it just stacks up. It’s a clear thing to just start to avoid, and it takes a lot of problems off the table.
Jack: Unless you’re a value investor. It’s an expectations versus reality thing, right? I mean — Oh, totally — and that’s the thing is he was talking about it. He’s like, “What’s actually cheap are the companies where estimates have to come up, and what’s expensive is the companies where estimates have to come down.” And if you think about it through that expectations framework, that makes sense because whatever people expect now, that’s what’s priced in. So maybe what’s cheap might not be what has the cheapest PE. What might be cheap is where things are gonna change in the future, where things are better than what’s priced in.
Matt: And this is the ultimate Michael Mauboussin, Professor Damodaran — this is the ultimate lesson there with what they come back to over and over and over again — is run the expectations against your estimates, see what makes sense, tack it back to base rates, tack it back to other things, make sure you’re not out over the skis with everybody else, and have your understanding there because that’s what presents the opportunity and you shouldn’t be scared off by something like a high price-earnings multiple.
Jack: So our next clip, we’re getting into Robert Hagstrom, and I actually went and watched this presentation that he talked to you guys about live at Fordham and it’s such a good presentation. And it talks about this idea of Harry Markowitz and modern portfolio theory and the impacts that’s had on investing. So here’s Robert telling the story of that.
Robert: I don’t think the publicity of investing was anywhere near — certainly not anywhere near what we are today. I mean, there was the Journal of Finance, was about the only periodical that you had out there that would look at academic research at that time. Now we’ve got multiples of them. There was no CNBC. There was a Barron’s, there was a Wall Street Journal and stuff like that. But this was an academic paper that really never saw the light of day for decades. I mean, clearly a decade or more. He wrote it and he finally got it published in, I guess it was ‘52, and nobody paid any attention. It got no press whatsoever. In the stock market world, in the economic world, in the finance world, nobody talked about it. Nobody had anything to do with it. He went, he left the university and went to work for Rand Corporation as a kind of a, you know, doing Fortran programming and stuff like that. And he was out of the loop completely.
So he writes this paper, and basically 14 pages. I think it had three citations in the whole thing. And he basically said that risk and return is something we ought to think about. And return is the expected yield of the investment. I got no problem with that, whether it’s the coupon of a bond or the earnings of a stock. Whatever you get out of it, that’s your return. And he says, “Well, if we use that as our return, the yield of that investment over time.” And risk, he said, was variance of return.
And that’s what stopped me cold in the tracks because this was the very first time anybody had ever said anything about... Well, let me put it this way. He said that risk was the variance of return, and already Graham was saying variance of return has nothing to do with risk. It has everything to do with margin of safety. If you buy something for less than what it’s worth, you’re acting with low risk. If you buy something above its intrinsic value, you’re operating with high risk. And then Graham goes on to say, you know, what stock prices do in the interim time is not a risky proposition to someone who doesn’t have to sell immediately, in a market that has that kind of volatility.
So Graham had already said, “No, that’s not what risk is.” And even in the book that he cites, John Burr Williams, in The Theory of Investment Value, John Burr Williams says risk is everything to do with buying these coupons above the stated intrinsic value. That’s very risky. Or if you buy them below the stated intrinsic value, you’re acting with less risk. So these two paramount people, Benjamin Graham and John Burr Williams, were saying, “No, risk is not variance of return, it is margin of safety.” But he plowed ahead. He said, “I don’t care. I’m just gonna run with this. This is my thesis, my theory.”
Matt: I want the quant guy perspective from you on this dividing line. And I think the history is so fantastic here. I love this so much. I’m very envious of you and Bogumil separately seeing this presentation live. I feel like I’m getting the directed TV version of the movie that I should’ve seen in the IMAX. What’s the quant take on— Well— risk and return?
Jack: Well, the interesting thing for me is I didn’t know any of this. Like, I didn’t know Markowitz wrote this paper and nobody paid attention to it for decades. And I probably should know that, but I didn’t realize he’s a PhD student writing a dissertation, and he writes this thing and basically no one cares for a really, really long time. And then it becomes eventually one of the most important things in investing. So that in itself was one of the most interesting things about the Hagstrom presentation, is just understanding the history of how we got to where we are today.
Matt: Something that crystallized in my head going through this with him — and actually talking it out, not just... I got to read the presentation, basically the slides and whatever else. I didn’t get to hear it and experience it the way you did. But then talking it out with him was the way that this provides the institutional backdrop for how we talk about portfolio construction theory so we can sell, institutionalize, and scale this thing. And that’s why nobody cares.
I think I told you about it before. There’s this amazing book called The Cult of Creativity. Did we talk about this?
Jack: Uh, probably, yeah.
Matt: So in the book, it’s basically that the way we understand modern creativity is basically a post-World War II experiment where we don’t wanna become communists in the US. So starting in like the ‘50s, and then certainly into the ‘60s, this is where brainstorming comes from. This is where all these ideas come from, and it’s like, how do we incentivize curiosity for the good of the group without devolving into, like, staying capitalists? And it produces some great things, like Pringles, which actually I’m not gonna say great. Not a Pringles fan. But that’s where it’s like they were in a brainstorming session. These executives come up with, “What if we do a tennis ball tube and we put the potato chips in there?”
And the idea here is you take modern portfolio theory and you figure out a way to institutionalize and scale it up. Nobody cares until you do that. The same thing happens in all these other fields where they have this weird history. If you’re willing to dive in and say, “But where did that come from?” and tack it all the way back. And risk-return invariance to have its sources in a paper that nobody read, and then gets co-opted by our industry — it changes our professional lives.
Jack: And whether you
Matt: agree with— This is madness—
Jack: yeah, whether you agree with it or not, it’s important to think through what it means for investing. So if I look at something I’m adding to my portfolio as a stock from the perspective of its volatility or the risk it adds to a well-diversified portfolio, what I’m not looking at is the actual business. I don’t typically care about the actual business. And it’s just important to think about it that way because someone like Hagstrom, who is buying businesses because he thinks they’re attractive and they’re gonna have better returns than the market over time — he’s not gonna like something like that, and it makes complete sense because I’m not caring at all about the business when I do that.
Matt: It made me think, like you keep playing that forward. This is my favorite part of this history lesson. You keep playing this forward, and it’s you start to go, “Well, the more we anonymize this thing, the better we get.” Like, let’s just make index funds. That sounds like a great idea. Now once we have index funds, we just can plot that curve again and we can show it, present it this way. Nobody has to care what any of these companies do. And if somebody ever cares, they’re like, “Wow, I wish I owned that company,” you can go, “Hey, it’s in the index.” It really is an amazing historical framing.
Jack: And what’s interesting is the worst part of this is not the index funds. The worst part of this is the active people. Because— Absolutely —what Hagstrom’s arguing in the episode is basically what happens is because active managers are using this, they’re effectively recreating the index fund, but they’re charging you a fee to do it.
Matt: A suboptimal version of the
Jack: index
Matt: fund— Right —by way of thinking we can use this theory to deliver some other result.
Jack: So this is not necessarily knocking index funds. This is sort of knocking an approach to active management that came out of index funds, which in some ways, if it’s done to its extreme, has no chance of producing any value because you’re effectively owning the index and charging a fee to do it.
Matt: And then the giant double back to like the Adam Parker point inside of this — and Crittenden is gonna put the nail in the coffin I think by the end of this conversation — but it’s this idea of it begets crappy active management. It begets the birth of the index fund as an institutional tool, which throwing no shade at that, just as an institutional tool for selling this. This is why it gets a structural advantage. And then the more we focus on the indices and we just forget that stocks even matter at all in the first place, it all kind of reverts down to like a flow story because that ends up determining where the expectations are and the whole nine. Pure joy watching these clips. What do we got next?
Jack: Let’s— we got Eric Crittenden, and you just mentioned him. This is one of the coolest things I’ve learned like in a while on the podcast is this idea of, you know, hedgers — there’s many people who have to hedge for many different reasons. And just thinking about how that flows through, who’s on the other side, what it means, it’s all really interesting. So here’s Eric talking about that.
Eric: We were discussing their compensation plans, and it was so confusing to me because they weren’t compensated on profits. A lot of them, they generally lost money on their trading. And it seemed like the more they lost, the more they got compensated. I’m like, “What is going on here?” I was an investments guy, right. And then I realized after a while of just, you know, fighting with them about this and digging for answers — ‘cause they were perplexed as to why I was confused — their job is to create negative correlation with the core risks on the balance sheet of whatever corporation they were working for.
And I thought, “Well, oh, okay, they’re hedgers,” right? So they’re not trying to make money. It’s a form of insurance to them, right? And I thought, “Well, how much of a difference can that possibly make?” And then when I realized that by hedging properly and reducing the bankruptcy risk, it lowered their weighted average cost of capital for the whole firm, so when they’re issuing bonds or raising money or whatever.
So they may lose 2, 3% a year on the hedging side, which can be leveraged up to 6, 9, 12% from someone that’s trading opposite them. But they’re lowering their cost of capital across the whole spectrum of the business so much that they’re making a lot more money. So there’s just these hidden things in the background that you have to drill through to see why these motivations exist.
So now in the example I use in the futures world, I think my favorite is the copper mining example. So let’s say you’re running a copper mine and copper’s trading at three. I don’t look at the prices, I just look at the risk typically. But just pretend that it was 10 years ago. And that implies a profit margin to you of, say, I don’t know, 10% profit margin. If the price of copper goes way up, you’re motivated and incentivized to produce more copper as fast as possible. But it’s gonna take you time to ramp up, right? You know, you gotta hire people and get more insurance and equipment and open up mines that have previously been shuttered. Maybe that takes you three, six, nine months to do all that work, and it costs you money, right? In the meantime, copper prices could go right back down to where they were, and then you just spent all this money chasing a profit margin that didn’t really exist, right? But if you pre-sell by going short futures, you can lock in that profit margin, right? And then with that certainty, you can go out and expand production. But you’re going short copper futures. Are you bearish on copper? No, you’re bullish because you’re opening up previously closed mines and hiring people, right? But you’re trying to protect your profit margin.
Jack: So I think, Matt, the most eye-opening part for me was this idea of lowering the cost of capital. So if you think about it, you’ve got people who are hedging whatever it is they’re hedging in their business, which makes sense. They have a risk associated with that, they have to hedge it. So you’d expect that’s sort of a version of insurance. They’re gonna lose money over time on the hedge. But what’s interesting is — as he points out — sometimes they don’t lose money in aggregate because basically by hedging it, they’re lowering the risk of their business, they’re lowering their cost of capital. So they’re effectively engaging in a trade they know is gonna lose, but in the end they win. And I think that’s really interesting.
Matt: I love this framing. I love this framing especially because it reminds you of the financial planning component of this — this is why you buy term life insurance. This is why you buy car insurance. This is why you buy all these things. What they actually do is they lower the need of you needing to come up with a lump sum of money in one of these consequences when something bad happens. And so from the hedger’s perspective, it’s less about a loss, it’s more about a necessary cost of doing business that enables all sorts of other things to thrive.
The counter thing that then creates is if you’re like, “These guys are out here perfectly willing to lose this money,” then you can just show up, and you should be levering up to their willing losses. And you can devise an entire strategy around basically being the croupier at the casino at the table. And what an incredible insight because now both people are satisfying a goal in a market, and it’s not just value investors and momentum investors buying and selling to each other all day. Kind of blew my mind.
Jack: This was great because Ben Inker from GMO, when he was on the podcast — and this is way at the beginning — he said this thing like you always have to... his one lesson for the average investor was you have to ask who’s on the other side of the trade and why are they willingly going to lose to you? And if you can answer those questions, then you have a reason to get a return. And Eric was able to answer those questions. I mean, that whole thing is basically explaining why there’s people on the other side of the trade that are willing to lose to Eric so he can produce a return. And he’s satisfying that, which I thought was really cool.
Matt: I think that’s the best part of this. He actually has a clear definition on who’s on the other side of the trade, why they’re willing to lose to him, and then how he can structurally make that an advantage for what he wants to do. Whether or not it holds up — this isn’t an endorsement on any of that — but it is a fascinating actual explanation on something that a lot of time people are just chasing around in the clouds with what the real answer might be.
Jack: So this next one, Matt, might bring you back to your Merrill days, but this is Adam Parker talking about when he worked at Morgan Stanley, the process of creating the outlooks and all the different people involved. So here’s Adam talking about that.
Adam: I didn’t mean to insult anyone with that. I mean, the idea, like when you work at a big firm, I used to work at Morgan Stanley, and the big firms have these year-ahead and quarterly outlooks, right? And you just have to imagine, whether it’s Goldman or JPMorgan or UBS or whatever, you have a lot of really smart people that have disparate jobs around the world, right? Interest rate strategy, economics, fixed income, equity strategy, currency, whatever.
And so the idea of having some firm-wide outlook — the way it worked at Morgan Stanley, and I assume it’s similar everywhere else — is there’s some meeting and it’s a couple hours. And when I was at Morgan Stanley, there were 44 economists, and they would tell you in their outlook for the economy. And then a few days later, the interest rate and currency and credit guys would tell you, “Okay, given the economic assumptions, here’s what we assume will happen to the currencies and the rates or whatever.” And then the last meeting, maybe two weeks after the original one, was the equity strategists were supposed to tell you what you thought of the US equity market. But ostensibly, you were supposed to use as inputs the economic view and the currency and everything else.
So every one of those meetings, almost like a broken record, I always thought we could definitely all be wrong, but there’s no chance we’re all right. You know what I mean? Like, you have that certain... And so I just thought I should just come up with my view because some of these things are really hard to forecast, like currency and interest rates for sure, and oil and other things. So we might as well just use our judgment. And I think we’ve said it’s definitely demonstrably true, which is the stock market leads the economic data, not the other way around anyway. So the economists’ meeting should be after the equity meeting. Do it in reverse, I guess.
And also, like, economic skill, which I think when I was younger — I’m older than you guys — when I was younger it was considered like a good degree, like scientific, you know. But now I don’t really think there’s a lot of skill to that degree because, like, Gemini or Claude or whatever, like, you can get all the economic data immediately, the forecasts. One of my criticisms of economists is I don’t think economists even know what already happened because the data gets revised or the definitions aren’t exactly what people think. And so we feel like it makes more sense to just use the information in stock price action to predict what’s gonna happen.
Matt: So let me just say, I love outlook season working at a giant firm like a Merrill Lynch because you would get a hundred different things from a hundred different perspectives. Yes, they would boil it down into a couple key reports and whatever else to try to put it all together for you. And I loved seeing how much people disagreed with each other. And I remember slowly becoming more and more aware of how annoyed so many people were that so many areas could say so many different things. And they’re like, “Why can’t they just agree?” And it was so perplexing to me to meet people who would be upset internally — like professionals in the business. And be like, “Well, this guy says this, and this guy says that.” I’m like, “But that’s what we want,” ‘cause in the market that’s what happens too. It’s like, “Well, I’d rather just watch CNBC.” And it explains a lot. It just explains a lot.
Jack: Well, it was interesting too to hear him talk about it because he was kind of at the bottom of that as the equity strategist, and it makes you understand how difficult the job of the equity strategist is because you’ve got the economists saying, “Here is our economic view that comes out of that.” Then you’ve got the sector people like, “Here’s our sector views.” And then it gets to the market strategist, and “Take all of that. That’s all true. Now make your outlook.” So you kind of can’t, to some degree you can’t disagree with the people above you, which makes it probably even harder to come up with these outlooks.
Matt: If you have the hierarchy — and that is one thing, and I can’t speak to this politically or whatever from my Merrill Lynch days — but when I was there, that was one of the things that was interesting when a market strategist would change or something else. You’d see they weren’t beholden to only agreeing with everything that came down, and they weren’t sitting at the bottom. So you would go like, “Oh, the market strategist has a different rates view or a slightly informed in a different way rates view on what the impact of rates are gonna be on borrowing, on cost of capital or whatever else in their model where they’re coming up with their S&P price target for the year and whatever BS metric the result is.”
And it was looking for those points of disagreement that’s fascinating. If you’re sitting at the bottom where he was and you now have to factor all these things into your model, you can understand why — I don’t wanna call it garbage in, garbage out, it’s still a useful thought experiment and exercise to link all these things together — but I can’t even imagine how frustrating it would be when you’re like, “How could the rates guy think this is true about inflation? But my commodity strategist says this, and now I’m the one who has to put this into one report together.” ‘Cause otherwise these guys are never gonna talk to each other inside of a report.
Jack: It was funny. It’s a different part of the episode, I think. I don’t think it was in that clip. But he’s talking about the idea that when he was there, the rates outlook was always wrong, like 100% of the time. And he’s like, “It’s always because of supply.” They were always thinking they were using supply to try to predict rates and like, “Oh, this supply of bonds is coming online,” or whatever, and it just never worked out that way.
Matt: It’s funny ‘cause the different people who are in those roles or fill those roles or leave the giant impression — they could’ve had a guy 20 years before that who got all the rates calls right for like five years in a row— Right —because he did that supply analysis. And now every poor schmuck who comes after him has to use that same supply analysis— The supply— because of the institutional memory, and then you can have a 15-year sucker streak. And it’s just funny. These are big, giant, slow-moving ships. The interesting part is remembering they’re usually populated by really, really smart people, and if you pay attention in an aggregate view of what’s going on, you can extract useful information from them. But Adam’s story just, yeah, it hit close to home. You’re right.
Jack: So the next clip, we’re back to Hagstrom again, and this is sort of the antidote to what he was talking about with Markowitz. Here’s Hagstrom talking about business-driven investing.
Robert: So the business-driven investor, Warren says, “We stay in the cathedral. We’re studying businesses. We look at the annual reports and the financial statements, and we think about how companies are run and the management.” Everything as if there was no modern portfolio ever invented. We’re just only interested in the businesses that we own.
But because to make a transaction to become an owner of that business, we’ve gotta step across the street and go in the casino. And the casino is the stock exchange, right? Whether New York, NASDAQ, whatever you wanna say. You gotta go in there and you’ve gotta make a transaction. “I’m going to buy shares in the business.” You go across the street, you walk into the casino, you give them your money, you get shares for the business. Now, what was great about Warren and Charlie and all the rest of the great fraternity is that they went in the casino and they immediately went back to the cathedral. And they stayed in the cathedral, right? And they studied businesses and they studied management, stuff like that.
But 99.9% of the people stayed in the casino. And they basically lived out the majority of their hours investing in a casino. And so they ended up buying and selling, buying and selling, buying and selling, and the whistles are going off, and the bells are ringing, and the champagne is flowing, and this is great, and stuff like that.
You really have to psychologically, emotionally tell yourself, “That’s a casino on the screen that I’m looking at. That’s a casino. And not everybody’s playing the same game that I’m playing. I’m a business owner. I have certain things that I look at. But there are a lot of other things that people look at at a casino, and they make buys and sells based upon a lot of other things that don’t make sense to intrinsic value, but that’s the way they play their game.” You really just have to emotionally and intellectually detach yourself from the casino. And once you do that, life gets much, much better.
Jack: What was really interesting to me is I kinda took a step back when I heard this clip, and I’m like, “How much of what I think about when I look at a stock has nothing to do with the business?” Or is not the way I would look at it if I was like buying a company down the street. Like if we go back to that Markowitz stuff, like all that’s irrelevant. Like if you were going down the street and looking at some store and you’re like, “I’m gonna acquire an interest in this store,” none of what they’re talking about there would actually apply to you. You’d basically be looking at the type of stuff Hagstrom’s talking about. You know, what kind of cash flow am I gonna get? Things like that. Not necessarily these volatility metrics.
Matt: The casino and the cathedral metaphor is insanely powerful and insanely useful. And just reminding yourself you don’t go to the cathedral to check your price. You go to the casino to check your price. But once you’re checking your price and you’re in the casino, you have to remember you’re in the casino, and now you’re dealing with odds and speculations and things in a different way — when you’re in the cathedral you’re just worried about compounding long-term value and nothing else.
The amazing part about what you were just saying too is when we’re working with clients who are business owners or we’re working with people who have a bunch of stock options at their company or whatever, more often than not, people actually do have to wrestle with both of these realities and take action based on both of those realities. So I actually see a lot of value in modern portfolio theory in the risk framework provided by risk as variance, but I also see how it has to complement. What happens is, you know, you own your own business, but then you’re saving into your 401k or your defined benefit plan or whatever else. And it’s like you need to understand both of these things, how they complement each other, and where you have different timeframes and different expectations on how you’re going to judge the merits and the success of this. And it’s a really weird puzzle to get into solving.
Jack: Yeah, and it’s interesting — the risk is variance thing. This is something we talked to Cliff Asness about as well, and Cliff’s point was it is risk, and I think that’s true. And a lot of it depends on who you are. Like if you’re Robert Hagstrom and you truly are not gonna care about the month-to-month, week-to-week volatility of your portfolio, then variance is much less risk for you than it is for your average client you and I see. Because the average client you and I see — you get these big moves, this big volatility — they’re gonna make bad decisions. And so in their case it is.
But it was just interesting to me, like to wrap it up on this, it was just very interesting to me thinking about if I invested tomorrow in a company down the street, like what would my process going forward be relative to what it is if I buy a business in the stock market? And it’s just completely different. Like, I wouldn’t be tracking it every day. I’d probably get a quarterly dividend and I’d pay attention to what’s going on with that or something. But it’s just — and not saying it’s right or it’s wrong — it’s just such a different path you go down. And that’s to Robert’s point, like we don’t look at stocks as businesses as much as we probably should.
Matt: It’s an incredible piece of nuance, and it’s so insightful for you to frame it exactly that way. Does make me wonder too, somebody out there is gonna run like the Berkshire Hathaway Standpoint back test, and we are gonna be suffered with that at some point in our future. Hopefully in a good way. But it is interesting, how do you pair up the cathedrals and the casinos? I don’t know. Maybe we have to start some ETFs. What do you think?
Jack: Yeah. Well, you and I started an ETF to try not hitting anyone’s needs, I would say. But nonetheless. But I did that back in the day, by the way, a long, long time ago. So— You’ve already learned that lesson —could attract the ETFs now. How were you
Matt: complicit in creating the ETFs you say you want?
Jack: I was very complicit. Yeah. But this is gonna carry through to all episodes now in the future ‘cause I’m— Definitely —I’m complicit in many things. But, back to Adam Parker. As a factor investor, you know, you study all kinds of factors and what truly impacts stock returns. And he has a very interesting one he pays attention to maybe the most. So here’s Adam talking about that.
Adam: I think the more down the income statement you go, the more BS is in there. So I remember years ago, United Technologies, which was run by a guy named George David, he was the CEO. And this is before they had the Raytheon transaction that spun off Carrier and Otis. But when he resigned — or retired — he said, “I’m proud that we beat earnings 59 consecutive quarters.” And I thought to myself, WTF? Like, how do you beat 59 — like, are the analysts uniquely stupid in this sector? No. Right? Are there cyclical businesses you’re in? Of course, they’re in helicopters, air conditioners, elevators. So it only just proves that there’s all these levers you can pull to fart it down the income statement to beat the numbers, right?
Sure, I’m sure economically there were some quarters where they just beat it and they operated well. I’m not saying there wasn’t a lot of that. But you can’t beat 59 consecutive quarters, which is basically 15 years, without having a lot of wiggle room. So answer one is you wanna be toward the top of the income statement, not the bottom, okay?
Answer two is more than any other margin level, the change in gross margin and the change in multiples — EV to forecasted sales or price forwards — are highly correlated. So businesses that have higher gross margin trade at higher EV to forecasted sales. It’s not necessarily true at the earnings level because of perception about over or under earning or other stuff.
So I think it’s that combination. I think as an analyst also, you can spend meaningful time getting a disparate view versus consensus on gross margin, right? ‘Cause if you think about gross margin, the best thing to get higher gross margins is raise pricing without any loss in unit demand, right? If I just charge more, if I charge more per widget and still sell the same number of widgets, that’s really high incremental margin, right? So we do a ton of work on this, and there’s all kinds of other things too, input costs on the cost side as well — depreciation, labor, material. So I think it’s because it’s more predictable, more analyzable, and the change is correlated to the multiples.
Jack: So I like this. Gross margin change is really interesting. So first of all, he corrected me in the episode — it’s not gross margin level, it’s gross margin change. And so the change in gross margin can be a very big predictor of stock price. And I think his point was very valid, which is — some people say, “Well, that’s not real profit.” But the good part about it is it’s not subject to manipulation as much. The further closer you get to revenue, the closer you get to the top of the whole thing, the less manipulation that can go on. And so I do think it makes sense.
Matt: Yeah, the less muddy it becomes. I’m curious, can you connect this in your head between... It makes me think of the Warren Buffett Werther’s candy conversion, the Munger whole thing, where it’s basically like you want the revenue business that’s growing at whatever rate, and you just wanna be able to raise prices — obviously you have input costs, you have other stuff, but it comes down to like pricing power as a main driver of quality. You don’t have to grow as fast on that top line revenue. You just have to grow steady, and the best way to do that is to just have pricing power. And if you can do that, you have a pretty damn good business. Is that kinda what’s going on here?
Jack: Yeah, I think to some degree, because if you have pricing power, obviously you can raise prices and your margins are gonna move in that direction. So that’s gonna reflect itself in positive gross margin changes over time. The other interesting thing is this is definitely something — and I should have asked him about this — but it’s just interesting to think about this in that light because we have so many more high gross margin businesses than we did before, and also businesses that have probably been able to, through the use of technology, continue to expand their margins over time.
So I would expect if you looked at a strategy like this, it probably would’ve been pretty heavily in tech, not just because they have high gross margins at a level, but because they’ve been able to increase those gross margins and take advantage of the efficiencies over time.
Matt: Absolutely. And it makes you wonder — good follow-up question for him next time. How do we think about that going forward? Because are we really in this weird place where we have these high gross margin businesses, and are they truly durable in the sense that this just continues for the next 10, 20, 30 years? It doesn’t seem like it should, but at the same time, it’s hard to understand why it wouldn’t when we look at a bunch of these companies.
Jack: Well, that’s good. That gets at software too, because right now actually margins have held up fairly well for software, but the whole idea is that that’s not expected to stay the same. And so through his framework, you’d expect — based on what’s going on with AI — the margins, however they’re gonna have to price in different ways, whatever it is, like where AI software’s just gonna take over what they’re doing depending on the software company. But you’d expect significant gross margin compression over time because of that, even if we’re not seeing it yet. And in his framework, you would expect that to negatively impact the stock price, which obviously it has.
Matt: Well, on the theme of changing your mind as the information changes, I think we should play this next clip from Eric Crittenden.
Jack: This was great. Eric and Jason Buck — who we should give credit to as the co-host who did— The
Matt: pimp of vol himself,
Jack: Jason C. Buck. Oh, let’s not get into that. We don’t wanna go that direction. All right. Or what did one of the commenters call him?
Matt: Oh, that’s right, Tom.
Jack: Yeah. He’s like— Our
Matt: good friend Tom. Thanks to our co-host Tom.
Jack: Yeah. I can only hope. We got a comment on it like, “Amazing insights from Tom.” And we’re like, “Oh, who’s Tom?” I mean, I think he was referring to Jason. I can’t say for sure when he said Tom, but he said Eric and Tom, I think so. It’s either you or Jason he’s talking about.
Matt: It’s either that or the AI comment that was hallucinating another person into the episode, which I could also accept. But yeah, Tom. Thanks, Tom. We appreciate your hosting this episode with us.
Jack: So here’s Eric and Jason talking about adjusting your strategy over time.
Jason: I think what Matt’s hinting at as well is — I think he’s actually hinting at the hardest piece to this, like systematic trading, right — is how much do you evolve and iterate versus tinker, and what’s the right time to do it and when’s not the right time to do it? Like, as you’ve evolved throughout your career and iterated to this point — you launched Standpoint in 2020, you had the tools that you have then. You’re going through this drawdown, you’re getting redemptions. All of that external pressure is so much that I think that’s the time when you wanna tinker the most. So what hurdles do you put in place to make sure you don’t tinker?
But like you said, maybe technology’s evolved, maybe certain things have evolved. Maybe you do need to tinker, and like you’re saying, it’s an art. So maybe kind of open that up for us a little bit. I think that’s one of the hardest questions for anybody to answer. Yeah. And especially guys like me that like to design systems and build them, do you just build it once and then just sit on your— Right
Eric: butt and run it for the rest of... No, I tinker a lot on the research side. But I’m very aware of how dangerous it is to bring new concepts into something that’s working well. The way I look at it is everything’s a trade-off, and everything has unintended consequences. And it’s kinda like a matrix in my mind. If you want to do something, what’s the upside? What’s the downside? What are the potential unintended consequences and the unintended benefits as well?
So I tinker a lot just on the research side. I look at things, especially after drawdowns — what could’ve been done differently? And you’ll get an answer. You’ll get plenty of answers. You know, I could’ve done this differently. I could’ve used some form of profit targets. I could’ve used covariance or copulas or whatever to kinda squeeze out the risk and see where they were starting to converge and whatnot. And it’ll always look great right then, but then you gotta go back in time and apply it continuously through time, and you’re like, “Wow, okay. It worked great two times in 50 years, but the rest of the time it was a huge drain on your profitability, or it actually increased risk.” So you need to be intellectually honest about these solutions or quote unquote “improvements” that you’re seeing.
So it doesn’t stop me from... You know, I’m curious and I like these kinds of puzzles, but I’m very, very skeptical about introducing them with other people’s money if they don’t solve more problems than they create. I think the rigor there is really important in that. It is. And there’s a humility too, right? For some people, myself included, it’s hard to just sit on your hands and do nothing. But that’s simply the right answer eighty-five percent of the time in this business. If you have a good thing, don’t mess it up. But it’s hard when you’re in a heightened emotional state — your thinking’s not clear, but you don’t know your thinking’s not clear, so you’re tricking yourself into like, “No, we should be doing this,” right?
Jason: That’s the spin-out. But hopefully you have good team members and everybody that keeps you in check, and good people on your board to maybe be a sounding board so you can maybe sit on your hands better than maybe you want to, you know, touch that keyboard. It also helps to not be particularly emotional, so I fit that.
Eric: Thankfully. Yeah, exactly. I was, uh... I don’t think I’ve ever asked you this ‘cause I could just guess what your answer would be, but like, that drawdown last year was one of — you know, we both studied the space and these trading strategies and styles — that was one of the worst drawdowns for decades for most, for a lot of trend following managers.
Jason: And so we always have heard this every decade, every few years: trend following’s dead, you know, Trump’s trade, you know, it’s a faster acceleration, it’s never gonna work again, it’s too big of players in the space. I’m trying to think of all the reasons and excuses people gave that it won’t work. Do you ever even pay attention to any of that, or you just know it’s gonna eventually come back?
Do I pay attention to it? This time around, I did not. I have in the past where I’ve listened to this and I’m like, “Well, could they be right?” ‘Cause I’ve spent a lot of time studying why trend following even works in the first place.
Eric: Like, why should you be able to do this and extract money from these markets? I mean, you’re trading against the smartest people in the world, the hedgers and the commercials and whatnot. But I mean, I have a theory as to why trend following works. It provides liquidity to hedgers in their moment of need. And from an accounting perspective and from a supply-demand and, you know, the physics of real life — that in my mind just has to be true. So trend following should work. The question is, can you survive the path traveled? Are you diversified enough and your leverage isn’t too high? You’ll be able to survive the wiggles, ‘cause a small wiggle can be a big wiggle if you’re using too much leverage.
The naysayers that said trend following is not gonna work this time around — it’s the same crew of people over and over and over again. I understand their perspective. I used to be on that side. I was an arbitrage guy coming out of college. I just dug in and looked at the math myself and said, “No, trend following is actually a legitimate way to extract a very valuable and very large risk premium from the futures markets.” And I fully expect it to work long term, as long as you don’t over-leverage and you diversify properly.
Jack: This is interesting ‘cause you guys talked a lot in the episode about this idea that during the tariff situation, trend followers like Eric went through probably one of the toughest times they’ve ever seen in their career. Obviously because things reversed really, really quickly.
And no matter what signals you’re using, even if you’re mixing — he mixes short, medium, and long — you can’t adjust that fast. And so when things flip that quickly, you end up in a problematic situation. But talking through, like living through that — and I’ve done it a million times as a factor investor, living through that — how do I change my strategy? Do I change my strategy? How do I weigh what I believe in over the long term versus what I’m seeing in the short term? Has something fundamentally changed? Those are just really, really tough questions, and Eric has a really thoughtful way he works through this type of stuff.
Matt: I love, love, love, love the way that Eric explains you basically build the model, and then you respect that you can’t sit on your butt. And this reminds me so much of some of the stuff that Hagstrom said too in this clip and in the broader episode. There’s again a very, very strong tie-in between many of the things Hagstrom said and Crittenden said, which sounds weird at face value, but if you go through these episodes, you’ll see them.
And it’s this idea that once you’ve built your model, you have to trust your model. And this is what Jason’s getting at in the beginning of this clip — you build the model, you trust the model, but then you do tinker, but you tinker in the forms of experimentation. So you have an idea of what might work, and then you rigorously go out and test and experiment with it. Do I really now fully understand this thing to the degree that I already understand my current models? And when you go through that experimenting process — as Eric says a number of times — you get surprised. It starts off looking like a brilliant thing, and then the deeper you get down the rabbit hole, you’re like, “If I fit this in, it lowers my returns or increases my risk, or it does something that I don’t want.”
But that constant puzzle-solving with experimentation as a replacement for actually tinkering with the core model — that sets a really high threshold for what you let in and what you let out. And that rhymes with what Hagstrom’s talking about. It’s like the pie always has to add to 100. If you’re gonna make room for something else, you have to make room within the 100. You can’t just invent new space. I guess you can if leverage, but for sake of this argument, 100 is the whole pie, and that’s the end of the story.
Jack: And it’s interesting too to think about — it’s not necessarily changing your strategy if you change something. And I don’t know if it was in the clip, but Eric talked about in the episode that he hasn’t changed his core strategy. So he went through this process and he decided, “I’m not gonna change my core strategy,” but I think it was nickel he did take out. So one of the asset classes he was trading, he stopped trading it. There are many different ways this can sort of manifest itself in terms of how you think about making changes.
Matt: Yeah, and make the change for the right reason. I believe, if I remember correctly with the nickel example, that’s where you go, “Most of this market is controlled by a bunch of Russian oligarchs, and there’s not any sane reason to do business with these guys or be on the other side of the hedging equation or whatever else. So we’re gonna take this out because this behaves by a different set of rules than we would expect from any normal, open, regular market.” And that’s the kind of self-awareness where you go, “I think I’m at a structural disadvantage here, even if mathematically it should be there.” Don’t try to impose an is into
Jack: naught.
So our final clip here, this is another Hagstrom clip, and this is a great, great story. This is him meeting Bill Ruane at a baseball game. So here’s what Bill told Robert.
Robert: Right after I wrote The Warren Buffett Way, it was at the annual meeting. And this was the days that the annual meetings were on Mondays, right? In the old days, they were on Mondays, and it was gonna be at the Holiday Inn Convention Center. It was right after the book came out. On Saturdays, they’d have a baseball game, and Warren would dress up. The farm team was the Omaha Royals, after the Kansas City Royals. He would dress up in a baseball uniform, he’d go out on the pitcher’s mound, he’d throw the first pitch. And all the shareholders are screaming and yelling, and it’s a real great time. And I’m sitting on the first baseline, there’s a fence there, a metal fence, and some popcorn.
And up next to me walks Bill Ruane. Now, Bill Ruane was a classmate of Warren Buffett, and he was also the guy who was recipient — along with Rick Knutson — to take on some of the Buffett partnership money when Warren shut the partnership and put it all into Berkshire Hathaway. Some of the people went into what was then launched as a Sequoia Fund, which was the repository for some of the Buffett partnership money.
And I recognized him — he didn’t know me from Adam — and I said, “Ah, Mr. Ruane.” I said, “It’s such an honor to meet you. Congratulations on all your success, and Sequoia Fund is just quite amazing.” I said, “I’m Robert Hagstrom.” And he goes, “Oh, Robert, I... That’s so nice to... Oh, congratulations on your book.” And I said, “Oh, I really appreciate it.” And he goes, “Well, what are you up to?” And I said, “Well, I’m gonna try to manage money like, you know, Warren taught us to do.” And he goes, “Oh, good. All right, so you’re gonna put together a fund or portfolio?” And I said, “You know, something like that. I don’t know.”
But he goes, “Listen, can I give you some advice?” I said, “Absolutely, Mr. Ruane. Absolutely.” He goes, “Well, you’re not gonna take my advice.” I said, “Well, wait a minute.” I said, “Mr. Ruane, I assure you, any advice that you give me, I will take it very seriously and I will incor—” And he goes, “No, you won’t.” I said, “No. Yes, I will.” And he goes, “No, you won’t.” I said, “Just tell me, what is your advice?”
And he says, “Well, you know, you’ve got this book and you’re a disciple of Buffett and, great for you. And you’re gonna get some people that wanna manage money like Warren, and they’re gonna be very hyped up about that. But there’re gonna be a lot that are gonna really be a problem for you, and they’re gonna be yelling and arguing about why don’t you own this, and why did you buy that.” And he goes, “I want you to fire all of them. Just fire them.” And I said, “Okay, Mr. Ruane, I’ll fire everyone.” He goes, “No, you won’t.” He goes, “You’re a young man. You’re starting out in business. You’re trying to build a practice. You’ve got a family, you’ve got kids, you’ve got a mortgage, you’ve got education.” He goes, “You’re not gonna fire them. You’re gonna try to convert them.” And I said, “Well— Mm-hmm —maybe I’ll try to...” He goes, “Don’t waste your time. It’s just too hard. Either they get it or they don’t get it. And the people that don’t get it, you’re gonna spend 90% of your time exhausting yourself trying to convert them.”
Jack: This is just a really cool story, Matt. This is something — first of all, he’s 100% right about this. Like, you’re like, “Oh, I’m gonna fire the clients that don’t follow my strategy or they question what I’m doing.” It doesn’t work out that way in the real world.
No, nobody does it.
Matt: No, well, some people do it. Bill Ruane apparently does it. Nobody else does it. It’s so hard.
Jack: Yeah, ‘cause obviously — and especially when you’re initially building your business, like he said. You have to take, you know, I remember back in the day, we would have — and we’ve adjusted a lot of this over time — but you’d have these clients that would come in, like the horse race thing. I don’t know if you ever had this. They’re like— Oh, I know about the horse race— “I’ve hired you and two other managers, and whoever outperforms after year one, I’m keeping them and firing the other two.” And way early in my career, we took that person because you need the assets. I mean, we don’t do that anymore, but that’s the type of thing. It’s just very hard to do. Go ahead.
Matt: I’m eternally grateful to very early on... I feel like in my memory it’s very early on. I’m sure it exists somewhere, but Barry Ritholtz wrote a post about being put in the horse race, and I’m so happy I read it at least earlier on in my career that it’s forever stuck with me, where he basically explains whenever he gets a letter like that — and this is where I feel like it must’ve been right after the financial crisis or something. Somebody’s like, “I just came into some money. I have a million dollars. I’m gonna give $100,000 to 10 different managers. Whoever does best after year one gets the rest of the pot. I’ll fire the other managers.”
And he breaks it down. He’s like, “Okay, so here’s the response to this guy. A, no, I’m not taking your money. But B, here’s why I think you might find this valuable.” If you send me this and I have basically a chance of losing the money that you’re giving me today in a year, you’ve now incentivized me to go out and take the most insane risk possible. Because what you’ve just said is I’m gonna lose all this money in a year anyway if I underperform. So if you give me all your money and I lose all your money, I’m in the exact same place. Whereas if you give me your money and I hit the grand slam, then you’re gonna basically 10X the original starting capital, and then whatever I do from there. So the incentives you’re creating in the horse race create a lot of problems.
Now it’s not quite the inverse, but what he’s saying is also true. If people get what you do and that’s your highest value proposition, you should probably strip out the people who don’t get what you do. Because you’ll get so much farther concentrating with those people than you will with all the hassles that are gonna absorb the rest of your time.
The Pareto principle’s gonna rule everything no matter what. It’s an incredibly smart insight to get on the sidelines at a baseball game. I need to go to better baseball games. This isn’t happening to me at Phillies games.
Jack: Two things. Well, first of all, we did not do what you said in the horse race. We just used our standard strategies like appropriate for that client, and we lost, and after year one we were fired. I don’t know what the person at one did. But the second thing is, it’s interesting ‘cause I have kinda come around to this. Like later in my career, I do fire clients now, which I would not do for a very long time, but you’d be surprised how hard it is to do.
So it’s the whole thing like the people wanna date the person they can’t have like in high school. Oh, yeah. So once you try to fire the client, then they’re like, “Oh, no, no, no.” Like they won’t let you— You don’t fire me. They’re backing off on everything. They’re like, “Oh, no, no, I totally believe in the strategy.” So it’s like once you decide that you tell them that you don’t want them, then it’s like no, no. And now everything changes, and now their behavior is great for at least a short period of time till they just repeat it again.
Matt: What I’m hearing here is that the follow-up to Pimp of Vol is the Jack Forehand book, The Pimp of Flows, where basically you make sure— Well— you make sure they know how this game is played.
Jack: What you’re hearing is maybe in some weird world, the best client retention strategy is to try to fire your clients some. You know, that actually might be a successful, like some sort of reverse retention strategy.
Matt: Call Michael Kitces. Call— Right, exactly— and get a bunch of them. Can you imagine me— Alert them to this brilliant new strategy—
Jack: can you imagine me writing an article for Kitces.com about that?
Matt: Fire all your clients today.
Jack: I don’t think it would... Yeah, I don’t think it would make it past the publication standards there.
Matt: Well, you know, it might be worth the run on this. I do think what’s important about this too, though, is recognizing — it has to be what you said before about the growth phase of your company — it has to be a high-value offering. You can’t do this with a low-value offering. You can’t do this with a commodity service. If it’s a high-value offering and you have a niche of clients that you’re focusing on, you can actually build really successfully this way by making sure you have people who all get the core value prop that you’re offering, and not spending the time on the people who are fighting with you.
If you just have a commodity good or service, you’re kinda looking at it from a different way where you do need anyone who can fog a mirror, because it’s gonna be the statistics of churn that’s ultimately gonna drive your business. That differentiation, I think, does matter. You can’t just take this and apply this to everyone.
Jack: Yeah. What’s cool is when you do eventually get there — which I’m kinda there now — I don’t really have many clients that are complaining about anything. It’s a really cool place to be. But to your point, it’s a tough thing to get to because you don’t wanna turn away business and revenue.
But if you can get to the other side of it — and Hagstrom’s probably there too with a lot of his investors because he’s talked about this for so long— Oh, he’s
Matt: definitely there
Jack: now. Yeah. It’s a really cool place where you don’t have to... ‘Cause obviously if you bring someone in and they invest with you, and after six months they’re complaining about performance, and it’s just sort of normal performance variations, you pretty much know at that point there’s zero chance this is gonna be a long-term relationship. So you’re just buying like a year or whatever it is till they finally are gone. So there’s a big case to be made: just deal with it upfront.
Matt: Rip that Band-Aid off.
Jack: That’s right.
Matt: Because you have to ask that question: How am I complicit in creating the clients that I say I don’t want?
Jack: Oh, no. We’re gonna wrap that, aren’t we? Well, on that note, Matt, I’ll let you bring us home.
Matt: You’re watching Excess Returns. Make sure you go over to the Substack. Check out the stuff. We’ve got lessons from all these episodes. We’re trying to get it, if it comes through, the Robert Hagstrom presentation at the core of this. We’re gonna try to share that too. Look for it all over there, Excess Returns on Substack. Meanwhile, wherever you’re watching or listening to this, like, comment, subscribe, all the things below, and we are out.