CFA Society Chicago 31st Annual Dinner

The Chicago Cubs didn’t win the World Series like they did during last year’s Annual Dinner but the 31st CFA Society Chicago Annual Dinner was yet another terrific evening honoring 163 new CFA charterholders and two recipients for the Hortense Friedman, CFA, Award for Excellence. We also had fantastic keynote speaker, David Rubenstein, founder of The Carlyle Group.

During the evening, our newest charterholders were acknowledged for making substantial investments in their careers by passing all three levels of the CFA exam as well as completing the four years of relevant work experience required.  Earning the CFA designation requires a significant investment of time, energy, and tenacity demanding for most nearly 1,000 hours of study.  The new charterholders are joining an exclusive club of investment professionals that possess both a high level of investment aptitude and a commitment to uphold the highest ethical standards.

Congratulations to all the new charterholders!

CFA Society Chicago Chairman Marie Winters, CFA

On behalf of the Society, congratulations to all those who met the rigorous requirements to become a CFA charterholder. After acknowledging the new charterholders, two individuals were honored for the Hortense Friedman, CFA, Award for Excellence.  This award is presented annually to individuals who have demonstrated initiative, leadership, and a commitment to professional excellence.

Larry Lonis, CFA, and Marie Winters, CFA

Larry Lonis, CFA

The first award recipient was Larry Lonis, CFA, who has worked in the industry since 1989, first for JP Morgan and more recently for Bank of America’s US Trust wealth management group where he served as the lead portfolio manager for a REIT equity strategy. Currently, he serves as the COO for the specialty asset management unit specializing in direct investments in oil and gas, farm, commercial real estate, timber, and private business assets.  In Larry’s speech, he was most thankful for being able to have a career where he is paid to learn every day as well as work alongside the incredibly bright people that he has had the opportunity to work.  As his father would always remind him, the most valuable asset each of us own is our name, which we must uphold to the highest standard along with the industry and the CFA designation.

Robert Harper’s son, Blake Harper, accepts the award on his behalf.

The second award went to Robert Harper, CFA, (posthumous) who grew up on the north side of Chicago, attended the University of Illinois where he studied Finance, and earned his MBA from Northwestern University.  He started his career at Stein Roe & Farnham where he became a senior analyst and Partner.  He later spent 22 years at Harris Associates, where he was the first director of research and the first institutional portfolio manager.  Mr. Harper was known for his contrarian views and was actively involved with the Investment Analysts Society of Chicago, known today as the CFA Society Chicago.

As the Friedman awards concluded, David Rubenstein took the stage and captivated the audience with a collection of videos of himself, including commercials, one in which he was running a young girls lemonade stand in which he suggesting bringing in LP’s and taking the company public or an outright sale through an LBO, in another video he was out-lifting bodybuilders in the weight room and another, showcasing his rapping ability while promoting his firm, The Carlyle Group.  After several laughs, Mr. Rubenstein talked about how he started his private equity firm, The Carlyle Group, which led to a review of how his success at Carlyle lead him to contribute philanthropically to our society, and finally a list of predictions for the economy over the next 12-18 months.

Rubenstein grew up in Baltimore, the son of a blue collar Jewish family whose father worked at the post office and never made more than $7,000/year.  In hindsight, it was a great advantage to have the unconditional love of two parents that didn’t have a lot of wealth – you know you’re going to have to do something on your own to create your own success.  Rubenstein attended Duke, where his initial calling was into politics after being captivated by John F. Kennedy’s first inaugural address given on January 20th, 1961.  This is the speech when JFK famously said, “Ask not what your country can do for you, but what you can do for your country.”  Continuing with his passion for politics, Rubenstein subsequently pursued law school at the University of Chicago where he graduated from in 1973.  After law school, he went to work for the man who wrote JFK’s speech, Ted Sorensen, who saw Rubenstein was interested in politics, but that he didn’t have the skills to be a terrific lawyer.  From there, he worked as chief council for Birch Bayh, a former US Senator from Indiana, who dropped out of a political race 30 days after David joined leaving him without a job.  Rubenstein then found a job working for Jimmy Carter at a time when Carter was a 33 point favorite to beat our Gerald Ford.  President Carter later won by only one point.  One of Rubenstein’s jobs while working for President Carter was to fight inflation, and if you remember back to this time inflation rose as high as 19%!  Quite the contrast from several economists today more worried about about deflation in today’s environment.  President Carter later ran against a much older Ronald Reagan and lost, putting Rubenstein yet again out of a job.  Without your party in power in Washington, it’s safe to say it’s very hard to find a job.  “If you want a friend in Washington, go buy a dog.”

Reconsidering his path in politics, Rubenstein read a blurb in the newspaper that changed his life.  The article highlighted Bill Simon whom started an investment firm which performed a “leveraged buyout” in which it bought Gibson’s Greeting Cards from RCA for $1 million and made $80mm in two-and a half year period.  He had the ambition and entrepreneurial spirit to start the first private equity firm in Washington DC and recruited the CFO of MCI and an executive from Marriott to be his partners.  They named their firm “The Carlyle Group” after a hotel in New York, for which ironically none of them had ever stayed.  The first four investors in their fund collectively contributed $5 million, or $1.25 million each.  The first deal was Chi Chi’s, a fast food Mexican food company that was looking to go private after being a public company.  The investment turned out successfully and today Carlyle Group has grown to one of the largest private equity firms in the world.  Rubenstein attributes the tremendous success to the creation of numerous styles of funds: a small buyout fund, a growth fund, a mezzanine fund, a debt fund, an institutional fund, and last but not least a family of funds among others.  He and his partners then took this idea of a multi-faceted fund structure and globalized it.

At 54 years old, Rubenstein came across a second newspaper article that also had a significant impact on his life.  This time it was an article of the wealthiest men in the world according to Forbes magazine, where he was featured for creating a very large fortune.  After living two-thirds of his actuarial life, Rubenstein signed a pledge to give away nearly all of his net worth—donating his fortune to educational institutions, medical research firms, and volunteering his time by serving as Chairman of Kennedy Center, Lincoln Center, and The Smithsonian.  A few years later, a THIRD article changed his life, this time coming in the form of an advertisement.  Flying home from London to New York, he read an invitation that an official copy of the Magna Carta was being auctioned off, of which there are currently 17 copies of around the world.  Ross Perot had bought one in 1981 and had since decided to sell it.  Rubenstein prevailed in the auction and has now donated it to the United States National Archives.  He continued purchasing historical documents that had significant to our country’s founding including the Declaration of Independence, the Emancipation Proclamation, the Thirteenth Amendment of the Constitution, rare copies of the constitution, and the first map of the United States.  After acquiring these meaningful documents, he has put them in places where Americans can see them so Americans can be inspired to learn more about the history of our country.

Rubenstein left us with quick yet informative bullets on his forecast for the economy and private equity industry:

  1. We are not going to have a recession anytime soon.  We are likely to have the longest growth cycle in the post WWII era
  2. New Fed Chair Jerome Powell will continue the Federal Reserve’s rate increase trajectory. Expect a 25bps rate increase in December
  3. US unemployment rate will hold steady and we will stay near full employment for the near-medium term
  4. Core inflation will stay below 1.5%
  5. NAFTA will be renegotiated but we will not withdraw
  6. We will have a tax cut bill.  Corp tax rate will go to 20%.  AMT / Estate tax will go away and repatriation will occur.  401k, SALT taxes will be preserved.  Expect tax cuts to pass early next year
  7. US Dollar will strengthen as the US economy continues to strengthen
  8. Europe will grow GDP nearer 2%; China will slow down to 5.5% – 6%
  9. Middle East conflicts won’t get resolved anytime soon.  Expect us to still be in Afghanistan 5-10 years from now
  10. Don’t expect a military confrontation North Korea
  11. Brexit will occur, however it won’t unduly kill the British economy
  12. Global climate change regulation will stay in place and actually will be enhanced
  13. Cyber warfare will continue to be the most important issue, and threat, to our country today
  14. Life expectancy will continue to rise globally as emerging markets catch up to developed world
  15. Private equity returns will drift down, but still beat index returns; United States private equity will outperform globally
  16. Sovereign wealth funds will continue to be increasingly important to the industry
  17. Government will allow retail investors to invest in private equity
  18. The largest private equity firms will continue to increase market share and grow globally

Concluding on Rubenstein’s philanthropic effort, he left us with “If you can make your mother proud, that’s where you’ll find real happiness is in life.”  For all the great deals that Carlyle had done and even after going public, he never received a congratulatory call from his mother.  He did however receive a call every time he donated his money and time to a worthy cause.  Even though many of us in the room won’t have the wealth that Rubenstein has created, you can still dedicate your time and skills to help make the world a better place.  Go out there and “Do something that will make your mother proud!”

  

  

  

  

  

  

  

  

To view additional pictures please visit https://edwardfox.pixieset.com/cfa/.

Distinguished Speaker Series: Gary P. Brinson, CFA, The Brinson Foundation

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On May 24th, a packed hall gathered for lunch at The Standard Club in Downtown Chicago to listen to renowned value investor Gary P. Brinson, CFA, while he shared his latest thoughts on the markets. Brinson founded Brinson Partners, a Chicago-based asset management firm that was acquired in 1994 by Swiss Bank, the predecessor of UBS, for $750 million. After the sale to Swiss bank, Brinson ran the asset management division of Swiss Bank to what later became known UBS Global Asset Management. Many consider Brinson to be one of the investment industries greatest thought leaders, although likely by design, he left the audience lots to ponder in his Investment Market Conundrums presentation.

 

 

 

 

 

 

 

 

 

 

Using mean reversion with a 90-year historical lens. Brinson started off his presentation with a simple question: “What perplexes you?” and undoubtedly we moved on to what perplexes the investing legend himself. Despite volatility being at stubbornly low levels, the securities market today presents some very unique challenges and opportunities with macroeconomic datapoints that currently have meaningful deltas to their long-run mean. To start, real interest rates on long duration assets have turned negative in some countries across the world. Notably Germany (-0.9%), the United Kingdom (-2.0%), and Sweden (-1.2%) all have 10-year real interest rates that are in negatively territory and Switzerland, even further down the curve, with a negative -0.2% nominal 10-year interest rate. Theoretically it is an investment conundrum to hold capital to invest and to consider where you loan money to a government that inherently isn’t a risk free investment for a return that would leave you with less capital than when you started—and that is without a default!  Theoretically, it is very hard to compute the existence of long term negative nominal rates.

20170524_123647Europe has all sorts of problems; what about the U.S.? The U.S. has a 30 year nominal rate of 2.9% and after backing out a 2.0% inflation target a 0.9% real rate of return. Historically, from 1926-2016, the real return on a 30-year bond in the U.S. was 2.6% vs. 0.9% where it stands today. Mean reversion would call for this 0.9% real rate of return to increase 70bps closer to 1.6%. Turning to inflation, historically, inflation as averaged 2.9% from 1926-2016 and today stands at 2.0% as the difference between TIPS (Treasury Inflation Protected Securities) and the nominal yield. Semi-mean reversion says the likely inflation rate should be somewhere around 2.4%.  Inflation is largely governed by the velocity of money which beginning since the start of the financial crisis has plunged. This may or may not be permanent. If permanent, that estimate of inflation at 2.4% is woefully too low.  No economist seems to know why the velocity of money has slowed so meaningfully. Combining the mean reversion estimations, we should be observing a 30 year treasury rate closer to 4.0% real rate of return (1.6% nominal return + 2.4% inflation).  If the 30 year today (at 2.69% at the time of this publication) were to re-price to 4.0%, the value of that bond trading at a par value of $100 would fall to $81 market value.

Market expectations assuming mean reversion.  Now taking these mean reversion theme and looking at the equity market—one can estimate a nominal return for the S&P 500 at 10.0% with 5.8% in capital appreciation including inflation and 4.0% in income including dividends and share buybacks from operating cash flow (Note: ((1 + 5.8%) * (1 + 4.0%) – 1) = 10.0%). One can expect bonds to offer a 5.5% return, and net of a 2.7% inflation assumption a 2.6% real return compared to a 6.9% real return for US stocks. Comparing where we are today to 1926, P/E ratios are much higher, and dividend yields are much lower. There are a number of factors for this, but if one were to only consider mean reversion, one would expect a 2.2% real growth in earnings, leading to a lower market P/E ratio and a higher market dividend yield. If we consider the path were are on as a new investment equilibrium level and ignore the trends of the early 1900s, one could consider stocks to be fairly valued in this environment. Elevated P/E ratios shouldn’t be of concern and real growth rates of 4.8% (6.8% nominal) with real interest rate debt at 0.9%. However, if we believe real interest rates will increase to the long-term average of 1.6% and inflation to 2.6%, we should model returns on stocks to equal 8.0% (3.2% income and 4.6% capital appreciation) and the return on long term government bonds to be 4.0%. What is rather frightening is the market reaction we would see for the 30-year to trade at 4.0%– long term bonds would fall 19% in principal value and stocks would fall 25% in creating these forward desired return objectives.

20170524_130958Volatility expectations assuming mean reversion.  Standard deviation of large cap stocks was 19.9% from 1926 to 2016.  Over the past year, the markets have average 13.3%. Again if we assume semi-mean reversion, volatility should increase to 16.8%. The risk premiums have also been subdued across all asset classes and in a similar manner these should also increase. The conundrum is what we are now finding is both volatility and correlations are remarkably unstable. These lead financial analysts and portfolio managers with a very tough question – what should we use as the input for volatility? The correlations of returns between the S&P and the 10-year has declined meaningfully and recently went negative.

Share buybacks – A return “on” or “of” investment? Share buybacks should be viewed just as a dividend – a return on investment for shareholders. Today the companies that make up the S&P 500 offer a 2.1% dividend yield, and if we add share buybacks as an additional return on capital this figure increases 40bps to 2.5%. However, how much of these share buy-backs are being financed with debt? Brinson pointed out that using debt to subsidize share buy-backs is a return “of investment, not a return “on investment.

Active vs. Passive Management. To conclude, Brinson switched gears and discussed the hotly debated topic of active versus passive management that left many wondering if he and his firm was either an “expert” or “lucky” coin flipper. He gave the example of 10,000 people in a room where each person was tasked to call their coin flip correctly ten times in a row. Out of the 10,000 people in the room, only nine would be able to accomplish the feat of calling heads or tails correctly ten times in a row. Now these nine coin flippers were clearly one of the 10,000 that got lucky – randomness makes one think you’re looking at something meaningful when you’re really only lucky. Randomness is pervasive in the securities marketplace, and if you make the wrong assumptions thinking data has statistical significance is can lead investors to make very poor decisions.

Tying it all together – A Book Recommendation. Brinson concluded with a book recommendation – The Drunkard’s Walk: How Randomness Rules Our Lives by Leonard Mlodinow written in 2008. The book dissects statistical concepts such as regression toward the mean and the law of large numbers, while using examples from wine ratings and school grades to political polls.

May 2017 Investment Exchange Forum: Investing in Asia

The Investment Exchange Forum was held on May 10th at the CFA Society Chicago office at 33 N LaSalle St. The group had lively discussions on the topic at hand surrounding Investments in Asia and broader stock pitches we were considering making investments in or currently held positions in.

David W. of Morningstar started us off with pitching Albemarle Corporation (NYSE: ALB)–a global developer, manufacturer, and marketer of highly-engineered specialty chemicals including lithium, a key component of David’s thesis. Lithium is used in the batteries of electric cars and David believes the market is underestimating the long term potential for electric vehicle adoption. While the market may view the developers of the electric car market such as Tesla at full value (or some would argue over-valued), the way to play the trend is by betting on the suppliers and miners of the components that make up the electric car battery. As adoption grows and as fuel standards continue to increase, all auto manufacturers will have to adjust and likely move into the either fully electric or hybrid vehicles. These secular changes will ultimately drive an increased need for electricity (positive for utilities), lower demand for gas-focused energy (negative for energy) and higher demand for materials used in battery components such as lithium and cobalt (positive for chemical/mining companies). Risks include the phase out of current federal/state incentive programs, lower oil prices making gasoline cheaper, and the still relatively high costs of implementing a fully electric vehicle versus a gas combustion engine.

Matt C. of US Bank also proposed an investment in Asia and two in the US REIT market, New York REIT (NYSE:NYRT), iStar (NYSE:STAR), and Hunter Douglas (AMS:HDG). We started off looking at New York REIT as a liquidation arbitrage play with the perceived liquidation value well in excess of its share price of $9.69/sh as of 5/10/17. New York REIT is an owner operator of 19 properties, which aggregate 3.3 million rentable square feet in primarily office assets in New York City. On January 3rd, 2017, NYRT shareholders approved a plan to liquidate the company. The investment thesis is supported by a number of factors including private market transactions for New York City Class A office rents in the low 4% cap rat rate range. A 4.5% cap rate on last quarters reported NOI equates to a $12.50/sh share price for NYRT. Winthrop Realty Advisors was appointed as the liquidation manager for the assets in March 2017. An incentive plan is in place where Winthrop would participate in added upside bonuses if the liquidation amount totals over $11/sh. We believe Winthrop’s management team would be hesitant to accept the terms of the agreement if they didn’t believe they could achieve over $11/sh in liquidation value. Winthrop Realty Trust, a diversified REIT run by NYRT’s existing management team, excluding CEO Wendy Silverstein, announced its liquidation in April 2014. The initial liquidation estimate was “at least $13.80/share”; to date, $9.25 of dividends have been paid, and the 2016 10-K suggested the remaining assets are estimated to be valued at $9/share, taking the total liquidation estimate to  $18.25, or 32% in excess of the original estimate. As stated in a proxy filing dated September 26, 2016, the company received an offer from a publicly traded REIT for $11.25/share in December 2015, excluding the Viceroy hotel.  With fundamentals in New York City office stable, we fail to see why a 20% discount to this prior offer should exist in the marketplace today.

After our meeting, NYRT reported first quarter results under the liquidation basis of accounting after the close on 5/10/17. The liquidation basis of accounting requires that management estimate the net sales proceeds on an undiscounted basis as well as the undiscounted estimate of future revenues and expenses of the company the through the end of liquidation. The net assets in liquidation at quarter-end were valued at $9.25/sh—disappointing investors in after-market hours sending the shares down 9% after hours. The earnings call provided further clarity around the management team’s liquidation strategy. No assets can be sold until debt assumption has been reached on World-Wide Plaza ($875mm) which includes mezzanine lenders. The debt should be assumed in the near term and there are currently no other assets on the market other than WWP which is expected to close by the end of 3Q17. Liquidation expected to be completed by the 1Q18, however company is not under distress. The company has 2 years to liquidate the holdings (until 4Q18). NYRT is open to someone acquiring NYRT as portfolio, however will continue to proceeding with liquidation efforts.

Two other companies discussed included iStar (STAR), a US mortgage REIT that turned into a landlord after the recession of 2008. Matt likes investing in REITs, particularly smaller cap mortgage REITs because he believes there is a lot of mispricing in the market. The background is that the company hasn’t paid a dividend since 2010 and they have been soaking up their NOL’s as they sell off properties they have foreclosed on. Matt said the company believes that shares could be worth two to three times current trading levels if the assets are broken up and sold separately in the private market. Finally, Matt presented Hunter Douglas (AMS:HDG) which is an overseas company operating in two business segments—window coverings and architectural products—both which provide the company with remarkable cash flows. The company is based in the Netherlands and is 70% family owned leaving float at only 30%, a key risk for the investment. There is ample cash on balance sheet, however we discussed examples including Nokia and Emerson Radio where you can burn cash by investing in unprofitable ventures in your own business.

Nick R. of Oculus Asset Management proposed a number of investments in Asia including Cross-Harbour Holdings Ltd (HKG:0032), Methanex Corporation (NASDAQ:MEOH), and Swire Pacific Ltd (HKG:0019). Cross-Harbour Holdings is a $4.3B Honk Kong investment holding company that owns toll roads for tunnels that go into Hong Kong and owns subsidiaries that operate driver training centers. The company maintains 61% gross margins and has ample cash on the balance sheet creating a natural floor for shares. Share price performance has been astounding—since 2014 the stock has delivered an over 100% return doubling from near $5.50/sh to $12/sh where it trades today. Methanex is a China spread business that sells Methanol made out of coal in China, in which they possess a dominant monopoly. The Company operates production sites in Canada, Chile, Egypt, New Zealand. Finally, Swire Pacific Ltd, is a Hong Kong based company that is the Holdco of five diversified well-run businesses in Hong Kong. The business operates as a diversified conglomerate controlling an aviation manufacturer, a Coke bottler, tugboats and steamboats, and other subsidiaries. The company maintains 25% operating margins, however the largest risk to this investment is its lack of float with the private owners owning the majority of outstanding shares. Because of this, the company trades at a discount for both the lack of control and its conglomerate structure. Risks to these investments include currency risk, unique rules on the exchanges, poor corporate governance, and lack of float outstanding.

The Investment Exchange Forum is held every other month. Please check the CFA Society Chicago website to register for the next event.