Distinguished Speaker Series: Rob Brown, CEO, Lincoln International

Current drivers of the global M&A market and perspectives on how it may evolve going forward

On September 10th the Distinguished Speaker Series Advisory Group hosted Rob Brown to provide his insight on the M&A market over lunch at the Metropolitan Club. Brown is the CEO of Lincoln International. His firm serves private equity firms, corporations and private businesses around the world, providing advice when selling or buying a business, securing financing solutions, valuing an organization or portfolio, or navigating special situations. Brown has nearly 30 years of experience advising leading private equity groups, privately owned businesses and large public companies on divestitures, acquisitions and other strategic initiatives.

Brown is a recognized advisor and thought leader in the investment banking industry. He is a frequent guest on WBBM’s Noon Business Hour in Chicago, and a speaker and author on mergers and acquisitions-related topics. Brown sits on the board of UNICEF USA and the Dean’s Business Council for the Gies School of Business at the University of Illinois. He is also President of the Board of Regents at Saint Ignatius College Prep in Chicago.

Brown started with an outlook on the M&A market. Global M&A activity has increased year to date in 2019 compared to the same period in 2018. There have been around 230 M&A deals this year verse 200 in 2018. The P/E market has been robust as well. Following several years of growth with an all-time high in 2018, inflows have returned to more moderate levels. Activity in 2019 could be characterized by established P/E platforms getting larger, with new funds facing a more challenging fundraising environment. Despite the fundraising slowdown, a thinner slate of opportunities for capital deployment has mitigated the impact to capital supply, leaving significant dry powder available in private debt funds.

On the lending front, bankers are still providing funds while defaults, the bellwether of a slowing economy, have not increased in a material way. Overall, the continued trade/tariff uncertainty, slowing global growth, Brexit concerns, and mixed signals from key economic indicators about the likelihood and timing of a recession have given lenders a pessimistic view of the market. They are lending but looking for a reason not to!

Brown advised that valuations of businesses have grown to historic highs. This is due to several factors, the most significant being the tax cuts passed in 2017 (reduction of the U.S. corporate tax rate has made the United States a more attractive jurisdiction for inbound M&A activity and has likely increased the value of U.S. domiciled businesses), and the large sums of P/E money raised over the past several years looking to be invested.

Additionally, there is nothing on the horizon which makes Brown think these valuations would change in the next 3-6 months. Overall deal activity is great with high valuations being the norm. Brown advised that now is an excellent time to consider selling a privately held business. The M/A market could be close to its top as the number of private sellers entering the market is high. These entities are usually late to the market.

Brown noted that although the market is richly priced, a recession would not necessarily bring down M&A prices. It is more likely that M&A activity would cease, but as soon as there is an upturn in the market deals would flow again.

Browns kept his prepared remarks relatively short in order to answer audience questions.

Q: Should a recession occur would capital be available, or would the market dry up?

A: M&A firms have committed capital on their books. This capital would not be put into M&A deals, but left as idle, short term investments. The M&A firm will sit on these funds making a nominal rate and wait until the market breaks upward.

Q: How much of the high multiple business valuation is due to any cyclical effects?

A: Modeling of returns has dropped over the past several years. P/E should float based on a measure of public equity plus a spread. As the prices in the public equity market have risen, so to have the multiples for the M&A market.

Q: Is there pressure on the 2 and 20% fee schedule?

A: In 2009 when the market was in disarray the outlook was for a 30% reduction in P/E firms. This outlook turned out to be completely wrong. The overall amount of P/E firms is now greater than in 2009, and with the constant search for returns that will beat the market, the current fee structure is unlikely to change.

Q: What effect will negative interest rates have on the M&A market?

A: Low or negative rates have not affected the cost of capital. Capital has been cheap for an extended period.  Any nominal change in interest rates will have little to no impact.  What is more important is the availability of capital. It is the extension of investors risk appetite that is the greater concern. Investors are stretching beyond their comfort zone, getting riskier with their investments.

Q: What is the state of European M&A?

A: The trade war with China has caused a number of unintended consequences, one of which is that China has refocused its M&A activity away from the U.S. to Europe and Germany in particular. Lincoln’s office in Germany will set an M&A record in deals for 2019.

EQ vs IQ

Ask yourself – Am I intelligent? Yes. No. When I get enough sleep. All of these? Ask yourself again, am I emotionally intelligent? In general people respond in the positive to both of these questions – ‘of course I am intelligent’ (think about overconfidence). While basic intelligence may be more measurable, emotional intelligence is more imprecise. After all what does it mean to be emotionally intelligent?

On July 30th, CFA Society Chicago’s Professional Development Advisory Group invited Lee H. Eisenstaedt of the Leading With Courage® Academy to guide a sold out audience through what emotional intelligence is, how to improve it, and how to apply emotional intelligence to be a better leader.

Eisenstaedt focuses on helping individuals and teams realize peace of mind and confidence from being more effective leaders who are able to make a bigger impact and create higher-performing organizations. He uses workshops, assessments, and executive coaching offered through the Leading with Courage® Academy which is based on his Amazon best-seller Being A Leader With Courage:  How To Succeed In Your C-Level Position In 18 Months Or Less. He is also the co-author of the book Wallet Share: Grow Your Practice Without Adding Clients, and is a frequent speaker at national and regional conferences on the topics of leadership and client loyalty.

Eisenstaedt began by providing three takeaways of the presentation. They were:

  • Authority, position and title do not equal leadership
    • Leadership is about what you do, not where you’re seated
    • Authority can compel others to take action, but it does little to inspire belief
  • Leadership is about relationships and influence
    • Leadership happens when your influence causes people to work towards a shared vision
    • Influence and significance come from caring about and growing others
    • Leadership is about inspiring / motivating ourselves and others to create high-performing teams and engaged organizations
  • Being self-aware is a never-ending journey
    • Have the courage to seek feedback
    • Self-awareness keeps you relevant

Eisenstaedt explained that emotional intelligence is the ability to, Perceive, Understand, Express, Reason with, and Manage emotions within oneself and others. In a work setting, emotional intelligence is about how intelligently you use emotions to get positive results. Good to know but how is emotional intelligence important in the workplace? Eisenstaedt provided the following data:

  • 90% of what moves people up the ladder when IQ and technical skills are similar is emotional intelligence – Harvard Business Review
  • The World Economic Forum predicts emotional intelligence will be one of the top 10 employment skills of the immediate future
  • Skills like persuasion, social understanding, and empathy are going to become differentiators as artificial intelligence and machine learning take over other tasks – Harvard Business Review
  • TalentSmart found that 90% of top performers are high in emotional intelligence while just 20% of the bottom performers are high in it.

Eisenstaedt asked the audience to participate in an interactive phone app-based exercise. The audience was instructed to think about the best and worst boss they had worked for, rate them based on how those bosses made you feel, along with three words describing them. Once completed, Eisenstaedt put the results into a real-time word-cloud. Popular words describing best bosses included supportive, inclusive, and listener, while the adjectives describing the worst bosses were distant, self-serving and aloof.

Eisenstaedt provided a model of emotional intelligence applied to leadership qualities. There are six competencies that emotionally intelligent leaders exhibit.

  • Inspiring Performance: Facilitating high performance in others through problem solving, promoting, recognizing and supporting others’ work. Leaders that exhibit a more inspiring style often empower others to perform above and beyond what is expected of them.
  • Self-Management: Managing one’s own mood, emotions, time and behavior, and continuously improving oneself. Leaders high in self-management are often described as resilient rather than it’s opposite of being temperamental. Self-Management is important in leadership because a leader’s mood can be infectious and can therefore be a powerful force in the workplace.
  • Emotional Reasoning: Using emotional information from yourself and others and combining it with other facts and information when decision-making. Leaders high in this skill make expansive decisions whereas leaders low in the skill make more limited decisions based on facts and technical data only. Emotional reasoning is important in leadership because feelings and emotions contain important information.
  • Authenticity: Openly and effectively expressing oneself, honouring commitments and encouraging this behavior in others. Leaders low in this skill might be described as untrustworthy. Authenticity is important in leadership because it helps leaders create understanding, openness and feelings of trust in others.
  • Awareness of Others: Noticing and acknowledging others, ensuring others feel valued and adjusting your leadership style to best fit with others. Leaders high in this skill are said to be empathetic rather than insensitive. Awareness of others is important because leadership is fundamentally about facilitating performance and the way others feel is directly linked to the way they perform.
  • Present/Self-aware: Being aware of the behavior you demonstrate, your strengths and limitations, and the impact you have on others. This trait is important because a leader’s behavior can positively or negatively impact the performance and engagement of others. The opposite of self-awareness is to be disconnected.

Eisenstaedt returned to the best boss / worst boss exercise explaining the point of this was to confirm that better bosses exhibited high emotional intelligence, while the poorly rated bosses exhibited low emotional intelligence. Most of the words chosen by the audience could be directly related to the six competencies listed above. Eisenstaedt also pointed out that the way a boss or colleague makes you feel has a tremendous impact on your productivity.

Eisenstaedt shifted to explain basic neuroscience behind emotional intelligence and engaging with others. There is a base reptilian brain – this keeps you alive, controlling breathing, heart beating, saving you from threats. These include social oriented threats (loss of control over situations, lack of certainty in your daily life, etc.). While other parts of the brain control higher functions, the reptilian brain’s main function is to minimize danger or maximize rewards.

There are triggers that our reptilian brain reacts to. Feelings of trust, certainty, approval, sense of belonging, and fairness are rewarded in the brain with Oxytocin (a hormone associated with boosting trust and empathy and reducing anxiety and stress). On the negative side diminished approval or status, fear of being conned or tricked, lack of security, loss of control, unfairness, feelings of danger all cause the brain to release Cortisol (a hormone released by the body in stressful situations). Eisenstaedt gave suggestions on how to avoid triggers that lead to stressful situations. He used the SCARF method to identify and reduce those situations of stress.

  • Status: Represents your importance relative to others. An increase in status generates a larger neural response than money does.
  • Certainty: Humans are certainty seeking machines where any ambiguity triggers a threat response.
  • Autonomy: When we experience stressors the threat response is dramatically higher if we feel we have no control. Work on providing a feeling of choice, of control, of autonomy in every situation – try to offer alternatives and some sense of choice.
  • Relatedness: New or different people can trigger a threat response. Build trust and a sense of what we have in common by bringing people together socially, in teams, with shared goals.
  • Fairness: Unfair interactions or systems generate a threat response. Be more than fair and be generous with all, and in so doing so all must feel they are being treated fairly.

Eisenstaedt wrapped up with a suggestion to evaluate all your relationships (in particular the ones where tension exists). Use SCARF to help identify problem areas. Consider what those problems are in terms of SCARF and seek out ways to address and improve them.

POWER Breakfast: Mellody Hobson, Ariel Investments

On February 6th Mellody Hobson was the featured guest at CFA Society Chicago’s Power Breakfast series held at The Standard Club hosted by the CFA Women’s Network. Hobson, president of Ariel Investments, is responsible for managing Ariel’s business operations, development, and strategic initiatives. 

This event was a conversational interview and moderated by Linda Ruegsegger, CFA. Ruegsegger started by asking Hobson what she sees as current risks and challenges in the investment industry. Hobson answered by stating that most risks should be considered as opportunities to be exploited whether they are new/emerging or persistent risks. The proper frame of reference is key to this here. Hobson used a hot topic as an example; the movement from active to passive management, or the growth of the ETF market. The growth of the ETF/passive market has come primarily at the expense of active management. With wide availability, it can be an easy choice to go the passive route. While ETFs are not inherently bad or wrong to own, they will only provide an average return – beta. Since the average market return is the best one can earn, eventually investors will realize that obtaining alpha is a valued outcome, and they will understand that it is worthwhile to pay for an active return. Since an ETF portfolio can only offer the market return, reversion to the mean should favor the active manager.

Hobson brought up a related topic – fee compression and how different ages of investors evaluate the cost of investing. The latest generation of investors have been able to invest their entire (short) life with investments that are effectively free. There are any number of Vanguard, Fidelity, and Schwab products that are no cost or near zero cost options. There is no turning back from these products – they are becoming the default option for the market investor. How then does an active manager compete against these companies/products? These companies have scale, which cannot be easily duplicated, thus midsized companies could be squeezed out of the market leaving a barbell-type investment manager landscape with large, mega cap providers on one side, and smaller niche-oriented managers on the other. However, it is the smaller provider that can use their size to be nimble and capitalize on customization and client service.

Hobson noted another result of the increased use of passive investments. It is getting more difficult for a 401K plan to provide a combined suite of active and passive investment options. Active portfolios are being squeezed out due to their perceived expensiveness. She told the audience of a conversation she had with a trustee of a 401K plan noting the trustee would no longer consider including active strategies because of the price difference from passive strategies.

Ruegsegger brought up the great recession and asked how Ariel Investments made it through 2008-2009. Ariel underperformed in a material way during this period. According to Hobson this was the first time this happened. AUM fell due to market declines and significant client defections. Hobson developed a mentality of ‘just getting through’ to the next week, next the month, next the quarter and urged her staff to do the same. There was no payoff at the end of these periods in terms of gift cards, cake, or parties. The payoff was the opportunity to come back to the job of managing money for clients and hope that the next period would be better than the last. With this mindset came more focus from the staff, brutal self-evaluation, and admitting mistakes that were made. Hobson also developed what she called a depression baby mentality – scrutinizing all expenses, making due with what you have, a needs-only mentality. This mentality served Ariel well during that period. It is important to be able to hold this mentality not just in stressful times, but also in better times as good times will ebb and flow.

During the downturn Hobson also met with all Ariel investors – these were hard discussions as many long-term clients withdrew their assets. For the clients that remained, positive performance was not promised, but she told her clients she would not bet against Ariel. Patience was the key – after 2008-09 the Ariel midcap blend was ranked number one in the Morningstar Mid-Cap Blend category out of 311 funds that were in existence over the 60-month period ended March 31, 2014.

Ruegsegger deftly segwayed by asking if patience is ok when bringing diversity to the investment industry. Hobson answered with a resounding “No!” Lack of diversity is corporate suicide, she opined. Hobson mentioned a book by Scott Page, The Diversity Bonus: How Great Teams Pay Off in the Knowledge Economy. The theme of the book is that diversity will always trump intellect. Hobson recommended the book and gave an example from it about how the small pox vaccine was discovered. Although there were teams of doctors researching for a cure, the idea that led to the vaccine was not found by a team of (like-minded) doctors, but buy a dairy farmer – from a person with a different (diverse) point of view than the teams of researchers.

Most companies do not formally address lack of diversity, and while it is great to aspire to having a diverse workplace, a process must be in place to build and maintain a diverse team. First, there needs to incentives in place to promote diversity. Incentivizing behavior will get the desired behavior. Second, have a process in place to source different pools of people. One must look for talent in a number of pools – the source of talent must be diverse.  Firms must realize and accept that one person of color, creed, ethnicity does not make a diverse workplace. More than one of X, Y or Z is needed. Third is having a mindset of diversity. Building a team is not a choice of taking the best person or the diverse person. This is the wrong perception. To find and build a diverse team move away from looking for a skill or credential. Instead look for intellect and be willing to train. Most people have biases, but they usually do not realize this fact. Teach yourself and your team to identify bias. Hobson believes diversity at Ariel is what makes the firm special, it is a competitive advantage.

At the conclusion of the discussion, Hobson took questions from the audience. Several of the audience members asked questions directly related to her comments on diversity –

Q – Should legislation be used to improve diversity of corporate boards?

Hobson made some observations; 25% of public companies domiciled in California do not have any women on their board, and white adult men constitute 30% of population, but 70% of corporate board seats. It is painfully obvious that corporate boards need to be more diversified. However, while mandates for diversity forces us to look at the facts, the U.S. as a country does not handle these mandates well.

Q – When looking to fill a position should one find the right intellect or the person that adds to a more diverse workplace?

Hobson stated that when given the question of ‘should I hire the best person or the diverse person’ the answer should be yes. One must understand that it is not a choice of hiring one or the other. Circumstances will dictate the best person for the job provided that diversity is valued at the workplace. That someone does not have the correct skill set is not an acceptable excuse for hiring in a diverse manner. Any person can be trained to on aspects of the job that they may not have previously encountered. It is worth the investment to train in order to obtain a well-rounded, diverse workplace.

Distinguished Speaker Series: James Grant, Grant’s Interest Rate Observer

James Grant has a resume. Navy man. Journalist. Founder and editor of Grant’s Interest Rate Observer. Author of books that range from the Great Depression, financial histories, a presidential biography, a forthcoming biography about Walter Bagehot, and appearances on numerous financial programs. Grant was the featured guest speaker at CFA Society Chicago’s Distinguished Speaker Series on November 14, 2018. Over lunch at the JW Marriot, Grant gave his views on topics ranging from interest rates to asset valuations and finished with questions from the audience.

Grant started with a U.S. economic review of the past 10 years concentrating on the progress and consequences of the monetary / fiscal policies applied over this period. Grant noted in 2007/08, the largest banks were leveraged around 29/1. The same group of banks are now levered approximately 13/1. While the risk these banks pose to the financial system has been reduced by de-levering over the past ten years, the leverage ratio of the Federal Reserve Bank has moved in an opposite direction, now standing at all-time highs. Fed policies have created a risky and perhaps fragile economic situation. Although the Fed has the ultimate backing of the U.S. government, at some point the investing public could say “enough” as ultimately the term “risk-free asset” will come into question. Grant then compared debt loads to GDP, asking rhetorically what is the level of debt that inhibits a country from issuing new debt at any price? Japan’s ratio of public debt to GDP is around 228%, Italy’s is 130%, while the U.S. stands at 105%. None of these countries currently have a problem issuing or servicing their debt. However, Grant explained that the level of debt is not the key, but how a country is viewed in the eyes of the world markets. For example, in 1978 the U.S. was in the midst of a funding crisis and the debt/GDP ratio was at only 26%. While finances and balance sheets matter, it is the cycles of interest rates that dominate a countries ability to raise debt and the world economies appetite for it. An alarming fact is the level of U.S debt issuance (in terms of percentage of GDP) is at its highest point since 1945. Grant pointed out the incongruity of the U.S. bond market activity and the overall economy. The economy by any measure has exhibited steady and reasonable growth in the past 10 years. Yet the U.S. government continues to issue more debt and increase the overall deficit in the face of increasing GDP.

Next, Grant addressed the value of risk-based assets. The past ten years of near zero term rates has created a perversely low cost of capital. By holding interest rates to artificially low levels, asset prices have inflated abnormally. Companies have exhibited a vicious cycle of issuing debt and using the proceeds to buy back their stock thereby propping up valuations. Fed policy is the main reason why there are a number of mega-sized companies that have recently gone or are about to go public. The commonality among these companies is that they typically make no money, have remarkably high valuations, and have easy access to cheap capital. Think Uber – it has never been profitable, year-over-year growth is decelerating, and it continues to lose market share. Despite this documented financial condition Uber has been recently valued at an enterprise value over $70 billion.

To underscore his points, Grant cited the works of two other authors. The first was Ed McQuarrie, Professor Emeritus at the Leavey School of Business, Santa Clara University. McQuarrie is a part-time market historian who takes particular issue with the views popularized by Jeremy Siegel of a 6-7% average return in the stock market over time. McQuarrie’s position is that for decade long periods the stock market has had negative returns and there is not necessarily a reversion to the mean. Grant strongly advised the audience to read Dr. McQuarrie’s paper Stock Market Charts You Never Saw.

When Grant finished his prepared remarks he fielded questions from the audience.

Q – Given your outlook on interest rates and asset valuations, is the pricing of private equity realistic?

A – Grant answered with a quick “No”, and pointed to a recent disagreement between Palantir Technologies and Morgan Staley which has a stake in the company. Palantir has been valued in the $30B – $40B range and is looking to launch its IPO in 2019. Morgan Stanley has lowered the valuation of the company to a fraction of its private market $30-$40B valuation. What does it say to the current state of private equity valuations if the very banks that are to take a company public cannot agree with the company on valuation?

Q – In the current market environment where would you put capital?

A – As bond yields go up (a certainty in Grants eyes), gold will also go up. When the public losses confidence in a country’s fiscal management, there will be a flight from that currency.

Q – Given the state of the U.S. finances, what is the answer – raise taxes, lower spending?

A – The first step to fixing our financial crisis is something akin to a person dependent on drugs. Admit there is a problem. Setting aside the lawmaker (or the out of power political party) that calls for fiscal responsibility, the U.S. government as a whole must tackle the problem. It is more likely that there will be monetary disorder before the problem is addressed. If this is the most likely scenario, then investors should consider gold as hedge.

Distinguished Speaker Series: James Bullard, President and CEO of the St. Louis Federal Reserve Bank

On September 12th, CFA Society Chicago welcomed James Bullard, president and CEO of the St. Louis Federal Reserve Bank. Members and guests heard Bullard’s remarks over breakfast at The University Club.

The focus of the discussion explored a possible strategy to extend the U.S. economic expansion. Bullard noted that historical signals used by monetary policy makers have broken down, specifically the empirical Phillips curve relationship. As a result Bullard suggested putting more weight on financial market signals, such as the slope of the yield curve and market -based inflation expectations. Handled properly, these signals could help the Federal Open Market Committee (FOMC) better identify the neutral policy rate and possibly extend the U.S. economic expansion.

Following are excerpts from Bullard’s presentation “What Is the Best Strategy for Extending the U.S. Economy’s Expansion?

The Disappearing Phillips Curve

Prior to 1995 inflation expectations were not well anchored. Around 1995, the U.S. inflation rate reached 2 percent, and U.S inflation expectations stabilized near that value. Bullard interpreted this as the U.S. having an implicit inflation target of 2 percent after 1995, calling it the inflation-targeting era. The FOMC named an explicit inflation target of 2 percent in January 2012, but Bullard said he believes that the Committee behaved as if it had a 2 percent target well before that date. The post 1995 period in the U.S. coincided with a global movement among central banks toward inflation targeting beginning in the early 1990s. During this period, the 2 percent inflation target became an international standard.

Once inflation expectations stabilized around this international standard, the empirical relationship between inflation and unemployment– the so called “Phillips curve”–began to disappear. Bullard provided a chart showing the slope of the Phillips curve has been drifting toward zero since the 1990’s and has been close to zero for the past several years.

Current monetary policy strategy

The conventional wisdom in current U.S. monetary policy is based on the Phillips curve and suggests that the policy rate should continue to rise in order to contain any increase in inflationary pressures. However, in the current era of inflation targeting, neither low unemployment nor faster real GDP growth gives a reliable signal of inflationary pressure because those empirical relationships have broken down. Continuing to raise the policy rate in such an environment could cause the FOMC to go too far, raising recession risk unnecessarily.

Given that, Bullard suggested using financial market signals such as the yield curve as an alternative to the Phillips curve. The slope of the yield curve is considered a good predictor of future real economic activity in the U.S. This is true both in empirical academic research and in more casual assessments. Generally speaking, financial market information suggests that current monetary policy is neutral or even somewhat restrictive today. Specifically, the yield curve is quite flat, and market based inflation expectations, adjusted to a personal consumption expenditures basis, remain somewhat below the FOMC’s 2 percent target. Financial market information also suggests the policy rate path in the June 2018 summary of Economic Projections (SEP) is too hawkish for the current macroeconomic environment.

A forward-looking strategy

More directly emphasizing financial market information naturally constitutes a forward looking monetary policy strategy. One of the great strengths of financial market information is that markets are forward looking and have taken into account all available information when determining prices. Thus, markets have made a judgment on the effects of the fiscal package in the U.S., ongoing trade discussions, developments in emerging markets, and a myriad of other factors in determining current prices.

Financial markets and the Fed

Financial markets price in future Fed policy, which creates some feedback to actual Fed policy if policymakers are taking signals from financial markets. This has to be handled carefully. Ideally, there would be a fixed point between Fed communications and market based expectations of future Fed policy, i.e., the two would be close to each other. Bullard said that generally speaking, markets have currently priced in a more dovish policy than indicated by the FOMC’s SEP – they expect the Committee to be more dovish than announced but still not enough to achieve the inflation target.

Caveats on financial market signals

Financial market information is not infallible, and markets can only do so much in attempting to predict future macroeconomic performance. The empirical evidence on yield curve inversion in the U.S. is relatively strong, and TIPS -based inflation expectations have generally been correct in predicting subdued inflationary pressures in recent years. Therefore, both policymakers and market professionals need to take these financial market signals seriously.

Risks 

Bullard suggested that yield curve inversion would likely increase the vulnerability of the economy to recession. An inflation outbreak is possible but seems unlikely at this point. By closely monitoring market based inflation expectations, the FOMC can keep inflationary pressure under close surveillance. In addition, financial stability risk is generally considered moderate at this juncture. Arguably, these are being addressed through Dodd-Frank and related initiatives, including stress testing.

Opportunities

The current expansion dating from the 2007-2009 recession has been long and subdued on average. The slow pace of growth suggests the expansion could have much further to go. The strong performance of current labor markets could entice marginally attached workers back to work, increasing skills and enhancing resiliency before the next downturn.

Uncertainty

Another long standing issue in macroeconomics is how to think about parameter uncertainty, or more broadly, model uncertainty. Bullard pointed to two studies: Brainard (1967) suggested that when model parameters are in doubt, policy should be more cautious than otherwise and, Hansen and Sargent (2008) suggested that, in some cases, policymakers might want to be more aggressive than otherwise. This is an unresolved issue, but how to handle parameter uncertainty has been a concern for the FOMC for years.

Conclusion

Bullard re-iterated his position stressing that U.S. monetary policymakers should put more weight than usual on financial market signals in the current macroeconomic environment due to the breakdown of the empirical Phillips curve. Handled properly, current financial market information can provide the basis for a better forward-looking monetary policy strategy. The flattening yield curve and subdued market-based inflation expectations suggest that the current monetary policy stance is already neutral or possibly somewhat restrictive.

A Taste of Latin America

CFA Society Chicago held its latest social event on Marth 13th at the Mexican restaurant Pueblo. Pueblo specializes in traditional Mexican fare with a “contemporary twist”, and is located inside of Latinicity on the third floor of Block 37 (northwest corner of State and Washington). Latinicity features eight innovative kitchens, the sit down restaurant Pueblo, a coffee café, full bar, and lounge.

The program for the evening was simple; participants were to watch and learn how to make a three course Latin dinner with hands on instruction from Pueblo’s kitchen staff. The dinner menu included a side dish that each participant would make, while Pueblo’s chef, Marcos Flores would show the group how to make a soup and entrée.

Chef Marcos began the program explaining to the group how to make the first course, Aquachile Ceviche. Aquachile Ceviche is a Mexican seafood dish that includes shrimp, pineapple, cucumber, avocado, celery, tomatillo, serrano, and cilantro. Chef Marcos provided some basic guidance on how to properly use a cutting knife, and then provided specific instructions on how to assemble the dish. Each person made their Aquachile at their station, which were close enough together so that acquaintances could be made and tips could be shared. I found out from sampling my station mates Ceviche that the smaller diced the ingredients, the better the dish.  It is suggested the dish be served with avocado and tostadas, and if you like, beer and tequila.

Once everyone had finished creating their Aquachile, Chef Marcos explained the steps required to make a large batch of Aquachile Sauce to accompany the dish. In a large blender he combined; garlic, white onion, chopped celery, fresh grated ginger, 2 limes, cilantro with stems, 1 whole serrano, 2 ice cubes, 3 small whole tomatillos, and kosher salt. Once those ingredients were blended olive oil was slowly added to complete the sauce. Chef Marcos advised that the sauce should sit for several minutes before serving, chilled.

We relocated to the kitchen where preparations began for Ajiaco Soup – a creamy chicken and potato soup, and Lomo Saltado – a traditional Peruvian dish. The group gathered around Chef Marcos as he prepared the soup. He diced potatoes, and brought them to a boil. Next, he cut raw chicken into strips and browned them in a skillet. Potatoes, chicken, corn, cilantro, green onions, and other spices were then combined into a large pot and let simmer. Chef Marcos explained that Lom Saltado is a stir-fry dish that includes strips of sirloin, sliced onions, and whole tomatoes. Over a medium skillet with hot oil, sirloin was browned, onions and tomatoes were added and sautéed until they were soft. Chef Marcos advised that the dish is traditionally served over fries or rice.

Once those dishes were complete, the group headed to the bar where Pueblo’s head bartender had been making a batch of Pisco Sours, which is made of Pisco brandy, egg whites, fresh lime, simple syrup, and bitters. The Pisco Sour originated from Peru or Chile, and is considered a South American classic. The drink’s name comes from pisco, which is its base liquor, and the term sour is in reference to sour citrus juice and sweetener. One of our group asked the reason for using egg whites. The bartender explained it adds a soft, element to the texture of the drink, and egg whites produce a layer that floats on top of the drink, which is ideal for decorating with drops of bitters or highlighting a garnish.

With drinks in hand we moved to the dining area to enjoy the fruits of our and Chef Marcos’ labor.  Pueblo staff had assembled a large table with the dishes of the evening; the Lomo Saltado, Ajiaco Soup, each participant’s Aquachile Ceviche, the chilled Aquachile sauce, and tortilla chips.

Over dinner we discussed a number of topics from, the reasons that brought us to the event, to economic growth expectations given the passage of the tax bill coupled the general uncertainty that is endemic to the current administration. Several of the participants noted they wanted to take a cooking class but not invest in a full cooking course. A couple of those people remarked that their experience at Latinicity would motivate them to enroll in a cooking class and another couple advised that they had been to Pueblo before and enjoyed the food so much that they wanted to replicate some of the dishes. Our group agreed that the soup was the hands down winner of the best dish of the night. Regarding economic growth expectations? We decided it was more fun to discuss the events of the evening over another Pisco Sour with new found friends.

Distinguished Speaker Series: Rupal Bhansali, Ariel Investments

Rupal Bhansali was the featured guest speaker at CFA Society Chicago’s March Distinguished Speaker Series luncheon held at the Chicago Club. Bhansali is chief investment officer and portfolio manager of Ariel Capital Management’s international and global equity strategies. Her presentation was called The Power of Non-Consensus Investing.

Bhansali began with two examples of non-consensus thinking: the micro-lending phenomenon that has helped eradicate poverty in places like India and the rise of Silicon Valley business model that was radically different from what was conventionally accepted. These examples highlighted that non-consensus thinking can be applied to a variety of situations and disciplines, including investment management. Also, this type of non-consensus thinking can drive alpha in investment portfolios. Considering the non-consensus aspect of your research is a great way to determine if there may be alpha.

The aim of institutional asset management is to be correct – correct in your assumptions, correct on your earnings estimates, correct with rates of growth. The problem with being correct is that it gets you to the same place as other good investors. A research analyst that is correct along with the rest of the institutional market is not necessarily rewarded. Fundamental research is about finding alpha, which in most cases is akin to proving everyone else wrong. Being correct and non-consensus provides rewards. The question then is how to be behaviorally different but remain analytically sound?

Bhansali provided an example of applying non-consensus thinking to the investment prospects of a global tire company. The consensus view of this company (and tire industry) was that tires were a conventional part of a car, low tech in terms of manufacture (it is just rubber and steel bands right?), and that the market is driven by new car sales. That view seemed reasonable, certainly a consensus view at the time. She then offered a non-consensus view. Is the manufacture of a tire a simple process that can be copied by a competitor? Turns out no, tire manufacturing is an involved process that cannot be easily reverse engineered. Do consumers consider tires interchangeable? No – they have brand affiliation. The consumer also cares about safety, fuel economy, and performance, which provides the company a value proposition. What drives this market is miles driven, not new car sales. A sector and business that was consensus branded as a low tech, interchangeable auto part, turned out to be a high tech, branded, mission critical good. If you had a non-consensus view on this market/brand, outsized returns were made.

A second example of a non-consensus investment view was provided on the mobile phone market. There was a time when BlackBerry and Nokia were market darlings. In part, these views were based on advanced technology, great user experience, superior growth, and competitive product advantage. The market took those factors to be insurmountable barriers. In fact these companies suffered from an eroding advantage where their products were surpassed by other brands. Apple seized the opportunity to displace these companies with a better product and user experience, offering the market exceptional growth of its own – for a time. Bhansali remarked that the consensus view on Apple has been positive for too long. Apple also suffers from many of the factors that doomed Blackberry and Nokia: alternative options and equivalent user experience for a cheaper price. She also noted that the iPhone is the dominate driver of revenue for Apple. If iPhone sales falter, Apple returns will suffer.

Bhansali’s last example of consensus/non-consensus thinking was particularly pertinent to the audience. Currently passive management is the go to option for investors. It is consensus – low entry cost, simple, easy, a no-brainer decision, while active management exhibits high costs, might have hidden risks, and is an active decision. Seems like there is no hope for active management given this view. Passive management and ETFs are winning and the outlook for active management is bleak. However, what would a non-consensus view of this subject consider? Although passive management is low cost, it is not low risk. Passive management has come of age in a prolonged bull market. It has not been stressed in a recessionary, or bear market. What might occur when large passive funds try to liquidate at the same time? For starters, the bid/ask spread will widen – a crowded trade is a risky trade. The scale that helps keep the cost of passive management low also exposes it to be too big to liquidate. A non-consensus view of active management might consider that the ease of ETF investing doesn’t equal being right, that real active management pays for itself when true active management is identified with active share, fundamental research, and management that has skin in the game.

The audience then offered some questions to Bhansali:

Q: If you believe that alpha is everywhere then the universe of securities is huge, how do you screen down to a manageable amount of securities?
A: Start from a rejection perspective not a selection perspective. Good securities will be the residual.

Q: In your portfolio what type of downside protection do you use or recommend?
A: I do not use derivatives as they are too short term in nature, and one must get the timing and thesis right for them to be effective. Protection can be obtained via investment ideas – using securities that have low correlation with the portfolio.

Q: What makes a great research analyst?
A: Bhansali noted that although it less common today, that being a generalist was helpful to her evolution as a research analyst. She also advised that a good analyst should follow multiple sectors, and always examine the counterfactual – understand what will cause a company to underperform as much as you understand the factors of outperformance.

Corporate Governance in an era of Clawbacks, ESG, Mega-Managers, and Zombie Investors

Two expert panels came together at the Conference Center at UBS Tower on November 29th to provide insights to various aspects of board related corporate governance. The first panel, moderated by Eileen Kamerick, focused on Management and Directors. Kamerick is a current and previous board member of several financial and industrial companies and is an adjunct professor. The panel included Thames Fulton, managing director at RSR Partners (executive recruiting); Frank Jaehnert, member of the board of directors of Briggs & Stratton, Itron, Inc., and Nordson Corporation; and Todd Henderson, professor of law at the University of Chicago Law School.

Kamerick started with a question about board diversity – should investors care about diversity? Henderson believes board diversity is a top issue and gave the following example of why boards lack diversity. When adding board members it is typical to get one or two women and / or a minority on a board, and then the board stops diversifying. Boards go through a ‘we are diversified enough’ type of thinking. Boards also suffer from a bias by what traits they look for in a new board member, which is usually for a former CEO or an operating exec type skill set. The pool of women or minorities coming from this group is already small, so the odds of getting a diverse board pick is reduced. The lack of diversity in the C-suite carries forward to the board. To combat the small pool of current/former women CEO’s corporate boards should look for a skill set other than a CEO, looking at other non-corporate entities such as universities, foundation/endowments or the private equity world. While the panel was in favor of board diversification, they were against legislation for mandatory board seats for women – legislation of behavior is not usually effective.

The panel then considered the topic of executive compensation, which is under the prevue of a corporate board. How should the board determine reasonable compensation? Jaehnert advised that the alignment of executive compensation with that of the shareholders is crucial, and that compensation should not be mandated but it should be provided in a defined and appropriate manner. Henderson considered that boards and investors spend too much time on CEO pay, because CEO’s are underpaid relative to revenues.

Kamerick asked the panelists to elaborate on how to set executive compensation. The panel advised that even if peer compensation or quasi government mandated compensation is used as a guide, the compensation committee is still responsible for setting executive compensation. However, most of these committees lack the training or background that is typically required. To obtain the appropriate skill set a board should have a current or former head of HR as a board member. In practice a board is more likely to rely on the job training, gathering executive compensation skills in a disjointed manner. One area that should be considered to obtain expertise on management compensation is the private equity world, which is better suited to choose compensation packages.

Kamerick brought up claw back policies – should they be used, are they effective. The panel as a whole was in favor of claw backs for a variety of instances including fraud, and for reputational damage as a result of executive actions. The panel advised a downside of claw backs; provisions of this sort would increase CEO pay. If a CEO understands that he/she will continue to be responsible for claims against them, the CEO will mitigate that by asking for more compensation. To combat this behavior the panel suggested using disgorgement of earnings, which would work better than claw backs.

The last topic the panel discussed was that of board services. An example why board services make sense was provided; when a corporation needs financial or legal help, the corporation hires a CPA or law firm to get the needed expertise. However, when a corporation needs governance (via a board) they hire individuals who do not have the collective depth of governance knowledge required. Hiring for board services should be allowed, but is illegal in Delaware (which exclude corporations) as well as in the Investment Company Act of 1940 (which exclude investment companies). An area in which there examples of professional boards could be found in the LLC space.

The panel provided some final thoughts based on audience questions;

  • If you have been on a board for a lengthy period of time, you are probably no longer independent.
  • Search firms are not favored by boards when looking for new board members. The board will seek out people they know or have had a history with.

 

The second panel focused on topics related to investors and asset managers. The moderator was Bob Browne, CFA, executive vice president and CIO at Northern Trust. The members of this panel included Gillian Glasspoole, CFA, senior associate of Thematic Investing for the Canada Pension Plan Investment Board; James Hamilton, CFA, director at BlackRock; and Kevin Ranney, director of product strategy and development at Sustainalytics.

Browne started with a question about analysis of a corporate board governance – is good or bad governance worthy of investor analysis? Hamilton advised that as an investor engagement of a board is process oriented, meeting with the board as well as senior management. It is through these meetings where one can get a sense of if the board is adding value. Depending on the size of the corporation, some education of the board regarding governance can occur. Larger cap companies have ESG processes in place, whereas the middle and small cap corporations are more open to having institutional investors provide guidance on ESG good practices.

Browne then asked the panel to consider difference between corporate governance in Europe versus the United States. Europe is more tuned in to ESG and looks to meet or exceed international standards. In Europe board diversity and executive compensation are linked to ESG targets. From the asset owner perspective Europeans are more inclined to think about ESG and have specific goals to address them. However, Europeans do not try to link alpha to ESG as much as it is done in the United States and Europe considers ESG value unto itself, without the need to have a positive correlation to alpha.

Another cultural board difference between Europe and the United States is the holding of CEO and chairman role by the same person (common in the United States, frowned upon in Europe). Hamilton considered that holding the CEO and chairman position is an acceptable practice, but other strong independent voices are needed in the boardroom to offset that dynamic.

The panel closed the program with a discussion regarding board transparency. How does an investor know if a board is doing the job they were hired for, and they are acting in the best interest of stakeholders? The panel noted in practice it is hard to determine if a board is engaged, but there are ways to get an overall idea. Do all the board members go to all committee meetings, do they have onsite visits to offices other than the headquarters? Learn to ask the correct questions and then you will uncover issues that will impact the value of the company.

Oak Brook Progressive Networking Dinner

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On May 23rd, CFA Society Chicago held a progressive networking dinner at Maggiano’s Little Italy in Oak Brook.

A progressive networking dinner allows participants to meet people in a casual environment over good food and drinks. Dinner is split into three rounds; salad/appetizer, main course, and desert. Each participant is assigned a specific table for each round / course. Then over that course, each person has the opportunity to provide an introduction and background to their table mates. After each course the participants reassemble at different tables and sit with a new group. The setup allowed me to meet 15 people during the event.

Conversation at the various tables went quickly from introductions to a wide variety of topics. I shared my first course with a quant from a prop trading firm, a member of an independent financial advisory firm, and a credit underwriter. Conversation ranged from the potential effects of the Department of Labor’s Fiduciary Rule, while another table mate explained how and where to attract funds for a hedge fund that he was starting.

My second and third courses allowed me to meet a new set of individuals including an ETF portfolio manager, wealth manager, institutional asset allocation manager, and financial consultant. These conversations also went in a variety of directions; the nature and constraints that must be followed to build and run a completion fund, the rationale behind currency hedging global trading in the current market, and the Bears trade for the second pick in the recent draft. Consensus on the trade was that it was rich.

My straw poll as to the effectiveness of the event was overwhelmingly positive. The participants I spoke with appreciated the setting, which allowed for more in depth conversation, as well as discussions that involved all of their tablemates.

This event was one of several CFA Society Chicago events that are held in the suburbs each year. The central Oak Brook location allowed 25 people to attend from a variety of suburban locations.

Distinguished Speaker Series: Will McLean, CFA, Northwestern University

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The Endowment Model in a Low Return World

On January 24th the Distinguished Speaker Series held its first luncheon of the year welcoming one of our own, Will McLean, CFA. Mr. McLean is Vice President and Chief Investment Officer at Northwestern University, and is responsible for managing the University’s $9.7 billion endowment portfolio. Mr. McLean gave an engaging presentation to a sold out crowd over lunch at the W City Center.

Mr. McLean’s presentation centered on the challenges endowments face given the low expected return environment. McLean explained that Northwestern University follows the Yale Model of endowment investing. The Yale Model is an investment philosophy developed by David Swensen, the Yale University Chief Investment Officer. This model deviates from the traditional asset classes (stocks, bonds, and cash) and uses modern portfolio theory to invest in alternative and non-liquid assets in the form of private equity and hedge funds.

Mr. McLean laid out five principles used to manage the University’s portfolio:

  1. Diversification – this concept is straightforward. As a portfolio becomes more diversified there is typically less correlation, and the risk of the portfolio is reduced. McLean advised issues could arise if a portfolio becomes overly diversified. Excessive diversification spreads capital thinly and causes an excellent investment to impart a marginal influence on the total value of the portfolio. Over diversification could also cause investment standards to be lowered – when anything can be added to the portfolio, standards are more likely to loosened.
  2. Equity oriented portfolios need to provide a higher than average return. Given the makeup of the portfolio and the annual needs of the University, the expected return of the portfolio is in the 7-8% range.
  3. Take advantage of the illiquidity premium. The time horizon of the University’s portfolio is near perpetuity. Therefore, it is reasonable to invest in illiquid / inefficient markets.
  4. Use active managers – invest in stock pickers in the right markets. Northwestern’s investment management team and board of trustees believe active management adds value, and more uncertainty should be good for active management. Different asset classes offer different dispersions. It makes little sense to invest in the large cap equity space when the difference between the top and bottom quartile manager is not significant. Seek out alternative asset classes with bigger dispersions of returns.
  5. Ensure that your manager’s interests aligned with your own. When engaging in manager selection find out who owns the investment management firm that is under consideration. What is the owner’s motivation? McLean advised that it had been his experience that when a manager takes their firm public with an IPO, the manager’s performance underperforms. Their motivation changes from client enrichment to self-enrichment.

Due diligence should also take into account other aspects besides the manager’s performance record. Consider the internal split of management fees; do they flow to a select few individuals? How much career advancement is available to junior employees at the investment firm?  Are employees likely to be nurtured and grow or leave the firm? Negative answers to any of these questions the long-term viability of the manager to produce alpha.

DSC_3299Once his prepared remarks were concluded, Mr. McLean took a number of questions from the audience.

How do you manage board expectations of returns?

Many board members are former money managers, thus they are well versed in the risk vs. return dynamic, and they have rational market expectations.

How do you manage spending over bad returns?

There is a spending policy, which is a board level decision. The portion of the University budget funded by the endowment does not vary much from year to year.

Does Northwestern University take a view on asset allocation?

The University does not believe in market timing or tactical investing.

What is the thought process of the allocating AUM to the hedge fund asset class?

The University’s current allocation is for a 20% weighting to hedge funds. In general, 1/3 goes to long/short, and 2/3 goes to uncorrelated macro and market neutral strategies. Overall Northwestern University views hedge funds as an uncorrelated piece of the portfolio.

How does one incorporate human phycology / behavior into choosing an investment manager?

The University has a standardized approach for manager selection. Behavioral patterns at the manager firm are collected and evaluated. The manager selection team has been trained (by outside sources) to ask the right questions during the interview process, and to evaluate the manager’s non-verbal answers. Current and former employees are also interviewed for their points of view. Overall, you must train yourself to consider the all aspects of the manager’s answers and behavior.