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

20170524_120455

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.