CFA Society Chicago Book Club:

How to Measure Anything: Finding the Value of Intangibles in Business by Douglas W. Hubbard

how-to-measure-anythingPath dependence is the phenomenon often used to explain why people sometimes persist with practices that are no longer optimal or economically rational. Statistics is another area where path dependence has struck. The statistical techniques that students learn in school, the ones that practitioners apply in industry, and the ones researchers use in journal publications often aren’t the best or the most appropriate ones but rather the ones that continue to be used because they’ve always been used.  Douglas Hubbard’s How to Measure Anything (2010) attempts to update some of those techniques for the 21st century.  In addition, he offers some refreshing perspectives on behavioral finance and the biases that adversely affect decision makers, even the so-called professional decision makers at the executive level in industry and government. Finally, he offers a unifying framework for decomposing complex problems into individual variables, assessing the value of reducing the uncertainty for each of those variables, measuring those variables, and finally determining probabilities through Monte Carlo simulations and Bayesian statistics.

Starting with antiquated statistical techniques, every former stats 101 student probably remembers going through some type of hypothesis testing exercise such as testing if a coin is fair, a drug works, voters prefer a candidate, etc. Those tests take a null hypothesis, such as assuming that a coin is fair, flipping it multiple times, and then determining the probability of observing a series of outcomes if the coin were fair. If the probability of observing a series of outcomes on a supposedly fair coin is less than some arbitrary threshold, usually five percent, the experimenter rejects the null hypothesis and concludes that the coin is not fair.  For example, the probability of observing five heads out of five flips on a fair coin is 3.13%, which would cause an experimenter using the five percent threshold to reject the null hypothesis that the coin is fair. The five percent shibboleth comes from the statistician Sir Ronald Fisher’s 1925 paper “Statistical Methods for Research Workers.” He wrote a year later in “The Arrangement of Field Experiments” (1926) that the threshold was arbitrary and that other thresholds may be used; however, the damage had been done and the five percent threshold remains as a venerated relic.

The whole process is a convoluted way to approximate the more useful question: What’s the probability of getting a heads on a given coin? The Bayesian approach to statistics, in contrast to the frequentist approach previously described, seeks to do just that. Mr. Hubbard notes that the term “Bayesian” was first used by Fischer himself as a derogatory reference to adherents of the approach named after Rev. Thomas Bayes. Rev. Bayes is credited with developing the first formulation of how new evidence can be used to update prior beliefs.  In the case of Bayesian statistics, new evidence is used to update prior assumptions about probabilities.

Once the distribution of the relevant variables or drivers is better known, Mr. Hubbard postulates a relationship between the variables and generates a hypothetical distribution of the phenomenon that one is trying to predict using Monte Carlo simulations. First developed to solve intractable problems in nuclear physics, modern computing power has made the technique accessible to anyone with a personal computer and an Excel spreadsheet. Instead of trying to compute the probability of a phenomenon such as rolling a two with a pair of dice (“snake eyes”), Monte Carlo simulations flip the problem by simulating thousand or perhaps millions of rolls and then determining what percentage of the rolls were twos. With an Excel spreadsheet, Mr. Hubbard shows how to calculate distributions and expected values for complex phenomenon after estimating the distribution of the underlying variables and their relationships. Monte Carlo simulations are seldom taught in introductory statistics courses. The topic is usually reserved for advanced classes and special topics classes even though the basics of the technique are no more complicated than regression modeling and several other topics that are covered in introductory classes.

With new statistical tools in tow, Mr. Hubbard then sets forth on finding what to measure.  Here Mr. Hubbard again notes a pernicious tendency among decision makers to either measure what’s easy to measure or what they’re already familiar with. The solution, Mr. Hubbard argues, is to triage variable before trying to reduce uncertainty about them by introducing metrics to quantify the costs and benefits of acquiring additional information about each variable. He starts with the Expected Value of Perfect Information (EVPI): What would it be worth to know a presently unknown quantity with complete certainty? He then works backwards to determine the incremental Expected Cost of Information (ECI) and the incremental Expected Value of Information (EVI). Finally, he adds a time component, noting that for some decisions the value of information is perishable. Mr. Hubbard notes that adding the time component can prevent what pioneering decision theorist Howard Raiffa called, “Solving the right problem too late.”

In addition to the tendency to measure the wrong things and measure in the wrong amounts, Mr. Hubbard notes several other behavioral and cognitive biases, such as expectancy bias and overconfidence. Instead of just rehashing problems that already have been noted extensively in the behavioral finance literature, Mr. Hubbard goes further and offers solutions, especially to the problem of overconfidence and quantifying uncertainty. When asked to calculate a 90% confidence interval for an unknown quantity, such as the wingspan of a Boeing 747 aircraft, most people choose too narrow a range. Mr. Hubbard shows that with training the average person can estimate ranges for unknown quantities such that on average the true value falls within their estimated range 90% of the time. The training, called “calibration training,” is simple to conduct and has a tremendous success rate.  Organizations should probably spend more time training their executives to become better decision makers given how much time and money as they spend sending them to conferences, hiring executive coaches, and giving them physical and psychological assessments.

When the CFA Society Chicago’s Book Club met to discuss Mr. Hubbard’s book in April 2017, most of the participants welcomed his fresh approach to quantitative and empirical problem solving. If there were any misgivings about the book, they were that it didn’t fully live up to its title: “Finding the Value of Intangibles in Business.” The participants would have welcomed more examples of how the techniques described could be used to value business units or firms that make intensive use of intangibles such as brand identity, intellectual property, or perhaps others.

Hopefully, this won’t be the last time that Mr. Hubbard crosses paths with the Society and we’ll get to fulfill that promise.

 

Building Investor Trust Through GIPS

On May 9th, CFA Society Chicago members gathered to hear a panel of experts address the merits of adopting the Global Investment Performance Standards (GIPS) in the Vault Room at 33 N. LaSalle. The eminent panel comprised a service provider, a regulator, and an asset manager user and included:

  • Daniel Brinks, compliance examiner with the Securities and Exchange Commission (SEC) with a focus on investment advisors,
  • Richard Kemmling, CPA, CIPM, CGMA, President of Ashland Partners & Company LLC, a specialty CPA firm that was a pioneer in the GIPS verification business, and serves over 700 client firms in that area.
  • Matthew Lyberg, CFA, CIPM, Senior Vice President and Director of Performance Attribution with Acadian Asset Management.

DSC_3715Anju Grover, CIPM, senior GIPS analyst with the Investment Performance Standards Policy Group of the CFA Institute (CFAI) served as moderator. In her opening remarks she pointed out that 2017 marks the 30th anniversary of GIPS which she described as one of the CFA Institute’s most successful products. Despite the fact that adopting GIPS is completely voluntary, they are widely recognized as a best practice for reporting investment performance by asset managers, asset owners, and consultants all around the world.

The first question Ms. Grove put to the panel was why GIPS would be important to retail investors. Brinks responded that retail investors are just as demanding of a performance standard as are institutional investors, and GIPS fills the bill. Lyberg noted that the line separating retail and institutional investors is blurring. The decline in the popularity of pension plans in favor of defined contribution plans is a primary example. Retail investors are the end users of DC plans and are responsible for investment choices, but the plans are designed, managed, and overseen by investment professionals. So they serve both retail and institutional masters. GIPS also adds a layer of due diligence to a plan, a theme the panelists repeated throughout the event. Kemmling pointed out that GIPS compliance is a common requirement for listing products on the investment platforms that advisors (he specifically mentioned Morgan Stanley and Merrill Lynch) use for their retail clients.

As to challenges firms encounter in adopting GIPS, the panelists listed:

  • Lack of adequate data, or records; difficulty in handling unique accounts,
  • Changes in operating systems that occur during implementation,
  • Incomplete buy-in from all parts of a firm (marketing, accounting, compliance, etc.), and
  • Full support from senior management. The latter point is particularly critical to assure firms commit adequate resources to attain compliance.

Why should firms bear the cost of GIPS compliance? Kemmling answered that they provide a “best practices” process for client reporting and that the verification process provides insight into industry practices. Brinks stated that while GIPS compliance is not required by law or regulation, he considers it in the category of “nice to see” when he examines an asset manager. The verification process is a second pair of eyes –outside eyes–on results reporting. He added that he observes fewer serious problems in general when he examines firms that follow GIPS. The CFA Institute has been training SEC examiners on GIPS so they can understand what the standards mean to adopting firms and apply that knowledge during examinations.

In response to questions from the audience regarding difficulties in complying with GIPS, the panel noted challenges in applying them to more complicated strategies such as currency overlays and alternatives. They suggested that this be a focus of the next revision to the standards which is already underway and targeted for 2020. This revision should also make the standards easier to apply to fund vehicles and for internal reporting to management. The current standards are most easily applied to reporting composite returns to clients, which was their original intent.

Regarding the breadth of acceptance of GIPS, Grover said the CFAI is still gathering data but counts 1,600 firms around the world that claim compliance for at least a portion of their assets. This includes 85 of the 100 largest asset managers who account for 60% of total industry assets under management. Lyberg noted that investment consultants are expanding the adoption of GIPS by using compliance as a screen for including firms in management searches.

When asked how a firm should begin to adopt GIPS, Lyberg suggested starting out modestly by writing high level policies and procedures and making them more detailed over time with experience. He recommended attending the CFAI’s annual GIPS conference to build knowledge and to make contact with other firms that have already adopted the standards. Challenges a firm may encounter include clients who demand using a different performance benchmark than what the firms uses for a strategy, tension between various stakeholders at a firm (e.g., between marketing and compliance), and resistance from legal counsel which often advises against bold statements of compliance that might seem to be guarantees.

As to the benefits to the public from using GIPS, Brinks stated that increased comparability leads to better informed investment decisions and more efficient markets. He noted the decline in fraud tied to inflated claims about performance since the introduction of GIPS thirty years ago. Kemmling noted that measuring the positive impact of GIPS is difficult but they were created for the benefit of investors and are an indication of asset managers’ commitment of resources in support of investors. Grover stated that adopting GIPS for greater transparency and comparability was simply “the right thing to do”.

For final takeaways the panelists offered the following:

  • Lyberg said GIPS levels the playing field among managers, adding that compliant managers couldn’t compete with fraudulent firms such as Bernie Madoff’s.
  • Kemmling, acknowledged that while compliance is not easy, it isn’t expensive and is certainly achievable. Most of the 700 firms his company verifies have less than $1 billion in AUM, indicating the success of small firms at complying with GIPS.
  • Brinks recommended that adopting firms think very carefully about how to apply the standards, looking to the future when writing their policies and procedures to avoid any potential conflicts between them and their capabilities.

CFA Society Chicago Book Club:

Blockchain Revolution: How the Technology Behind Bitcoin is Changing Money, Business, and the World by Don Tapscott and Alex Tapscott

BlockchainRevolution-674x1024Blockchains are simultaneously feared as a disruptive threat and lauded as a technological panacea, often with little understanding of how they actually work and often with little practical consideration of how they might be implemented. Don Tapscott and Alex Tapscott (father and son, respectively) assist the layperson in understanding how blockchains work and how they could be used in Blockchain Revolution (2016). The authors also, unfortunately, further delude the technological utopians by proposing seemly endless possible uses of blockchain technology while failing to address some of the practical considerations of implementation.

Starting with the positive, Blockchain Revolution is one of the first resources to both explain blockchain technology and to fully explore its potential uses beyond the now somewhat familiar bitcoin. Bitcoin is the digital currency created by “Satoshi Nakamoto” in 2009. Satoshi Nakamoto was the name that was used in internet chat rooms and the like by a person or group of persons who claimed credit for creating the cryptocurrency. Soon after creating bitcoin, Satoshi Nakamoto disappeared and the identity or identities behind the name never have been revealed. Replete with a dubious creation story, bitcoin maintains a religious, cult-like following despite scant uptake and usage. The history of bitcoin has been told elsewhere, including in Paul Vigna’s and Michael J. Casey’s The Age of Cryptocurrency (2016), which was the book of the month for the CFA Society of Chicago’s Book Club in February 2016.

What hasn’t been told widely until now are the other possible applications of the technology underlying bitcoin, the blockchain. A blockchain is nothing more than a ledger for recording transactions. The double-entry bookkeeping system that forms the foundation of modern accounting is widely attributed to Luca Pacioli, a Franciscan Monk and mathematician who lived in the 14th and 15th centuries. There are earlier claims to the discovery, which probably have some merit. There are probably undiscovered cave scribbles that merchant cavepeople used to record exchanges of spears and mastodon parts. As long as there’s been commerce, there’s been the need to record exchanges, and ledgers in some hasty form have probably served the part from time immemorial. The difference between blockchains and most previous ledgers is that previous ledgers resided with a trusted central party to the transaction, whereas blockchain ledgers are distributed, meaning that every member of a network retains a copy of the ledger. When there is a new transaction in the blockchain, members of the network that maintain the ledger verify the authenticity of the new transaction, append it to the chain of all previous transactions, and transmit the updated chain to the network.

That distributed feature is what poses the disruptive threat to numerous businesses that are based on intermediating markets. For example, the Uber business model is based on a central party that sits between drivers and passengers, links the two, and takes a slice of the profits in transaction fees. Similarly, Airbnb disrupted the hotel industry by intermediating the market for lodging by linking people who have spare capacity in their homes with travelers looking for a place to stay. Blockchains could further disrupt the disruptors by allowing those parties to transact directly and take out the middleman.  The Tapscotts mention several other less obvious areas where blockchains could be used to intermediate markets or keep records, such a land and property deeds, personal medical and financial information, stock and bond offerings, contracts, and wills. The authors even argue that intellectual property such as music and other artwork could benefit from blockchains by allowing artists to control access to their works and charge a royalty fee directly to end users when they access them.

The oldest and largest business based on intermediation is, of course, banks. The primary function of banks always has been to intermediate the market of lenders and borrowers. Without banks, potential borrowers could find themselves having to go door-to-door, pleading for loans and negotiating the amount and the terms of the loans with each potential borrower. Banks have always done that legwork primarily by taking deposits and issuing those deposited funds as loans. Add credit and debit cards, foreign exchange, settlement, custody, and clearing to the mix and banks make considerable profits just by sitting between market participants, recording transactions, and taking fees. The Tapscotts and other blockchain utopians contend that all such businesses based on market intermediation will become unnecessary and disappear due to blockchain technology.

The CFA Society Chicago Book Club members who met to discuss Blockchain Revolution during their March 2017 meeting agreed that the range of possible blockchain uses was enlightening but found the tone of the book overly optimistic and found the treatment of implementation challenges lax. Take contracts, for example. The Authors seem to presume that blockchains will obviate the need for traditional contracts and courts to enforce them. A hypothetical blockchain contract might look as follows: A stadium owner engages a vendor to fix the plumbing in his stadium. When a credible party who has access to verify that the work has been completed confirms successful completion of the work in the blockchain, payment is automatically distributed. But what if the stadium owner contests the quality of the work? Was the vendor merely to fix the plumbing so that it didn’t leak or was the vendor supposed to restore the plumbing to like-new status? What if the stadium owner was relying on the repairs being completed by a certain time so that he could host a concert? If the vendor doesn’t complete the repairs, is it liable for the foregone revenue due to the stadium owner’s inability to host the concert? These are not far-flung hypotheticals. Contract law deals with those issues constantly. It’s not clear how blockchain-based contracts will be any better than paper-and-pencil contracts in terms of interpretation and adjudication.

Safety and security of blockchains is given similarly little treatment. Assuming for the sake of argument that the double key encryption technology that blockchains use makes them impenetrable to hackers, they could always just access blockchains using stolen passwords. And unlike when someone fraudulently uses a credit card, there is no legal department at bitcoin to contest the fraudulent transaction or IT department to reset the password.

Blockchain usage will undoubtedly increase. Even without blockchains, market intermediation for a variety of products and services has become increasingly automated and that trend will continue whether by blockchains or by other means. The consequence of that for banks and financial institutions is that they won’t be able to rely as much on the simple act of intermdiation for revenue and will instead have to increasingly compete on knowledge and customer service. Even now customers no longer need banks to purchase a variety of financial products and services, but retail and commercial customers still come to banks and financial institutions for sound advice and financial planning—and to reset their passwords.

Despite its shortcomings, Blockchain Revolution is an important contribution to understanding rapidly evolving blockchain technology, and hopefully others will step up to fill in the missing parts of the puzzle concerning how blockchains will be implemented and administered.

Distinguished Speaker Series: T. Bondurant “Bon” French, CFA, Adams Street Partners

DSC_3661T. Bondurant “Bon” French, CFA, executive chairman of Adams Street Partners addressed a large gathering of CFA Society Chicago members on the topic of private market investments on April 5th at the University Club. Adams Street Partners is a Chicago-based manager of private market investments with over 40 years of history and $29 billion in current assets under management.

French began with a review of historical returns for private equity markets using industry data. Both categories he focused on, venture capital and buyouts, showed superior long term performance (ten years or longer) compared to public equity markets, but weaker relative performance for periods shorter than five years. He doesn’t consider the shorter term underperformance to be significant as success in private market investing requires a very long investment horizon, a feature deriving from the reduced liquidity relative to public markets.

French went on to provide a summary of recent market conditions and performance for both buyout and venture capital pools. His statistics showed that fundraising for buyouts rose sharply from 2005-2008 and then fell just as sharply during the financial crisis. Although there has been a rebounded since 2010, the $368 billion gathered in 2016 still hasn’t topped the pre-crisis amounts. The volume of buyout transactions has recovered much less so since 2009 leaving managers with considerable “dry powder” seeking attractive new investments. This is also reflected in data for buyout fund cash flows. From 2000 through 2009 calls for funding from borrowers regularly exceeded distributions out to investors. However, since 2010, distributions have far exceeded calls. Investors (and their managers) have been especially wary toward new investments since the crisis, a condition exacerbated by the high level of multiples on buyout transactions (similar to the situation in public markets). At more than 10 times enterprise value/EBITDA, these have passed the pre-crisis highs to levels not seen since before 2000.  This situation has driven Adams Street to focus on deals in the middle market which is less efficient, and consequently priced at lower multiples.

DSC_3654Also reflecting caution (and the effects of Dodd-Frank regulations), buyout deal leverage remains below pre-crisis levels (5.5 times in 2016 vs 6.1 times in 2007). However, terms of credit have eased as reflected in the market for covenant-lite debt. This has far exceeded the levels common in 2007 both in terms of absolute amount and share of the new issue market. DSC_3659This has helped the borrowing firms survive economic challenges and also allowed them an opportunity to remain independent for longer.

In the venture capital market (much older but smaller than the buyout market) new fund raising peaked in 2000 during the “tech bubble” and fell sharply when the bubble burst. The subsequent recovery was fairly muted, so the financial crisis had less of an impact on fundraising activity than in the buyout market. The $83 billion raised in 2016, while the highest since 2000, is consistent with the longer trend.  Cash flow in the venture market hasn’t been as persistently strong as in the buyout market because companies are choosing to stay private longer than in the past. Liquidity events, measured by number of deals and total value, peaked in 2014 for both initial public offerings (IPOs) and mergers and acquisitions (M&A). M&A, the larger of the two by far, has shown a smaller decline from the peak than has IPOs, and has held at levels consistent with longer term trend.

French concluded with a brief look at the secondary market for private investments (trades between private market investors as opposed to investors being taken out by IPOs or M&A). This market dates to 1986, but is showing healthy signs of maturing recently. Although the market hit a recent peak in volume in 2014 the decline in the following two years was slight—holding well above the prior trend.  Pricing, as a percent of net asset value, has also been rising. Transactions in 2016 were evenly distributed by the type of investor (pension funds, endowments, financial institutions, etc.) supporting liquidity. In 2016, transactions were more concentrated in newer funds because older funds (created before 2008) are shrinking from their natural positive cash flows, and have less need to trade.

CFA Society Chicago Candidate Mix & Mingle

stress-391659_1920With every passing day the CFA exam gets near and candidate stress levels rise. What could help? A free event with an open bar, appetizers and pizza! CFA Society Chicago organized an event on March 29th at Hotel Allegro where candidates poured in to relax and network with their peers. They discussed what was and what was not working for them (in hopes to hear similar stories for affirmation that they are not alone!).

Kaplan Schweser, co-host of the event, sponsored a raffle prize of their Review Workshop to a candidate which was awarded to Kevin Anderson. Bijesh Toila, Lecturer at Kaplan Schweser, was sharing his wisdom helping out candidates with any concerns they had and getting feedback on study materials. He views his organization’s partnership with CFA Society Chicago to be a success and looks forward to strengthening it. The Society’s organizing committee members and executives joined the event for moral support of candidates.

We wish all the candidates best of luck on their upcoming exam and wish them success on the path to obtaining their charter!

Executive Presence and Leadership Principles

Did you know it takes only four seconds to form an initial impression and 30 seconds to completely form a first impression? More shocking, 70% of workers are actively disengaged or not engaged per a 2012 Gallup survey. These statistics are not encouraging. On March 28th, after networking and snacks, Patricia Cook offered ideas on how to create better impressions and how to be in that 30% of truly engaged workers during CFA Society Chicago’s  Executive Presence and Leadership Principles event held inside the Vault at 33 N. LaSalle.

We know good leaders when we see them but what qualities should a good leader have? Attendees collectively offered Cook over 30 words and phrases. Building on that, we focused on six qualities and how we can individually build those out.

Great leaders:

  1. DSC_3647Have executive presence. People need to like you, trust you and want to be led by you. A leader with executive presence has charisma. The largest part of charisma is being present, self-aware and staying in the moment. Power poses increase confidence and charisma can be learned with practice.
  1. Leverage strengths and talents. Discover your strengths and the strengths of those around you. Develop and play these strengths. Your actual strengths may be different from your perceptions. A strength finder tool can help you separate perception from reality.
  1. Motivate others. Employees are most motivated by public appreciation and recognition of their accomplishments. Give employees a voice, make introductions for them, and let them know how their work impacts the bottom line.
  1. Communicate effectively. Ask “why” when working and problem solving. Also ask how you and your team can add more meaning to the work.
  1. Seek strategic opportunities. Make low points high points. Motivate and mentor. Reflecting is a key part of seeking strategic opportunities. Good leaders cannot be strategic without it.
  1. Drive for results. Set priorities and leverage relationships and teamwork. Ask for help with projects and tasks that are not your strengths. Focus on follow-through and ask for feedback.

This list may seem like common sense but may prove harder to implement in the hustle and bustle of our daily work lives. Remember, whether you are a junior staffer or the CEO, these leadership techniques can make you shine. In closing, Patricia noted that 85% of job success comes from people skills and the other 15% from technical skills.

Investing for the Long-term: Productivity of Capital Markets Expectations, and Portfolio Management

DSC_3571CFA Society Chicago presented a two-part symposium on Investing for the Long-term on March 7th at the Standard Club. Approximately 150 members and guests attended to hear Robert Gordon, Professor of Economics at Northwestern University and Deirdre Nansen McCloskey, Emerita Professor at the University of Illinois Chicago present their perspectives on productivity trends. Francisco Torralba, CFA, Senior Economist, Morningstar, Robert Browne, CFA, Northern Trust Bank, and Rick Rieder, CIO Global Fixed Income, BlackRock, then presented their outlooks for the capital markets.

Gordon highlighted the sharp slowdown in US GDP growth from 3.12% from the 1974 to 2004 to 1.56% from 2004 to 2015. He said that this slowdown resulted from a reduction in productivity growth and the labor force participation rate. He noted the Kalman Trend Annualized Growth in Total Economic Productivity, which rose to 2.5% in the 1990s because of the technology revolution, but has recently fallen to near 0.5%. The labor force participation rate has been affected by an aging population, fewer 18 to 25-year-old people in the work force, and passing the peak rate of growth for women in the labor force.

DSC_3590Gordon noted that growth and productivity are probably under estimated, but have always been under stated. He sees no indications that the distortions are worse today. He expects that both lower productivity growth and labor force growth will produce slower economic growth over the next decade.

McCloskey acknowledged that the current level of productivity growth has fallen. She observed that “falling sky” DSC_3579forecasts always follow events like the 2008 financial crisis and noted the perils of trying to predict future enhancements in productivity. She also stated that global economic growth will be positively impacted by developments in countries like China and India.

DSC_3587McCloskey highlighted her work on the role a change in attitude toward capitalism in the 1700s that augmented the 1st Industrial Revolution. She noted the evolution in literature from Shakespeare to Jane Austin in the portrayal of capitalist and the return on capital that they earn. Changes in attitude toward capitalism could drive growth in emerging economies.

An area of agreement between Gordon and McCloskey is the role of minimum wage laws and other restrictions on the labor market that prevent economic growth in areas like the west side of Chicago. They also support efforts to stop the “war on drugs” and support a negative income tax for low income people.

Outlook for Investors

DSC_3591Rick Rieder, CIO Global Fixed Income, BlackRock, noted the aging population and its demand for income and the role of technology pressing down inflation. He believes that the US economy is exiting an investment & goods recession. He also believes that September 2016 marked a turning point away from expansionary global monetary policy. He sees better economic growth leading to higher interest rates, and the potential for higher stock prices because of sales growth.

Francisco Torralba, CFA, Senior Economist, Morningstar, supports McCloskey view that trends in productivity cannot be predicted. He also foresees a pickup in economic growth and cited a Financial Analyst Journal article that links the payout growth rate to the GDP growth rate. A higher level of economic growth could be a positive development for equity investors through higher dividends.

Robert Browne, CFA, Northern Trust Bank, suggested that forecasters begin with “what’s easier to forecast.” He believes that identifying what is cheap is easier that what is expensive. In contrast, much of the forecast has been centered on the expensive, low yield bond market. He also noted that anticipating a range over the short-term is easier. Here, he believes that the election of President Trump may pull forward economic growth, which would be a positive for equity investors.

The consensus outlook seemed to be that long-term real returns for equities would be in the 4% to 5% range. These analysts generally favor US equities, US high yield bonds, natural resources, and emerging markets debt.

Vault Series: David Ranson, HCWE & Co.

David Ranson provided an enlightening presentation during the second part of CFA Society Chicago’s new Vault Series held on March 15 in the Vault Room of 33 N. LaSalle. Ranson is President and Director of Research at HCWE & Co., an independent investment research firm that was formerly a division of H.C. Wainright & Co. Ranson presented a simple, but effective model–based on his extensive research into capital market returns and correlations–that his firm uses to advise clients on tactical asset allocation. Their process uses historical market price movements to uncover predictive relationships between leading indicators and, highly-correlated, consistent outcomes.

The model’s simplicity derives from viewing the investment universe as comprising just four primary asset classes (exhibit 1):

  • Domestic bonds
  • Gold
  • Domestic equities
  • Foreign assets and physical assets (commodities, real estate, etc.)

Ranson 1_Page_02

(It’s important to note that the model considers gold as uniquely different from all other commodities.)

Ranson began by describing the role of capital migration in investment performance (exhibit 2). Capital migrates away from countries or markets characterized by economic stagnation, lower asset returns, declining new investment, and rising unemployment, and will flow to areas where the opposite conditions apply. Causes of the poor performance can be excessive government spending, taxation, and regulation, and “regime uncertainty” stemming from secretive or unpredictable policies.  These are difficult to quantify, but are usually accompanied by two more easily measured indicators: currency weakness, and rising economic anxiety (i.e., market stress).  These two indicators are the primary market signals the model relies on.  The price of gold serves to measure a currency’s value, and credit spreads measure economic anxiety.Ranson 1_Page_03

Ranson described four economic scenarios arrayed in quadrants defined by the change in the rates of economic growth and inflation (exhibit 3). Accelerating growth occupies the two lower quadrants and declining growth the top two, while accelerating inflation resides in the two right-hand quadrants and decelerating inflation on the left side. The scenarios (quadrants) determine the best performing assets.  Haven assets (bonds and gold) do best in the two upper scenarios when economic growth declines.  Risk assets (equities and commodities) stand out in the lower half of the array when economies accelerate.  When viewed laterally, financial assets (Ranson called them “soft” assets) that struggle against inflation reside on the left side of the array and those that do better against rising inflation (“hard” assets) reside on the right side.  Hard assets include gold, other commodities, real estate, and foreign equities.  (All foreign equities fit into this category because the model assumes they would perform comparatively well when an investor’s home currency is weak.) Putting the model together, shows gold as the preferred asset in the upper right quadrant (decelerating growth with rising inflation) and bonds preferred in the upper left quadrant (both growth and inflation decelerating). Domestic equities shine in the lower left quadrant (rising growth and decelerating inflation) while commodities and real estate are best in the lower right quadrant when both growth and inflation rise.Ranson 1_Page_04

Ranson presented statistics to support his model (exhibit 4). Separating the past 45 years of available data for the United States, he showed that when the rate of GDP growth accelerated from the prior year, the returns on equities and commodities always improved, while returns on treasury bonds and gold worsened.  When the rate of GDP growth slowed from the prior year, the reverse relationships held: returns on equities and commodities fell, and those for bonds and gold improved.Ranson 1_Page_05

Looking at inflation rates revealed similarly intuitive results (exhibit 6). When the CPI accelerated in a year, financial assets (both stocks and bonds) exhibited weaker returns, and gold and commodities did better than in the prior year.  When the CPI decelerated, financial assets enjoyed improved returns, while gold and commodities worsened.

Putting it all together (exhibit 11), Ranson presented an Asset-Allocation Compass with north pointing to heightened business risk, increasing investment anxiety, weakening economic growth and widening credit spreads. South points to the exact opposite conditions. East points to a weakening, or unstable, currency (measured by the price of gold) and west to a strengthening currency. He then filled in the best asset classes for eight points around the compass. His four primary asset classes occupied the diagonal compass points, corresponding to their positioning in the quadrant array:

  • Gold in the northeast
  • High quality bonds in the northwest
  • Domestic equities in the southwest
  • Hard assets in the southeast

Ranson 1_Page_12

Ranson assigned the primary points of the compass to sub-groups of the primary classes. The most intuitive one was Treasury Inflation Protected Securities (TIPS) pointing west (declining inflation, strengthening currency). Pointing south toward strengthening growth were risk assets: B-rated junk bonds, MLPs, and developed market foreign equities. Pointing east (rising inflation and a falling currency) were commercial real estate and C-rated junk bonds, assets exhibiting little influence from changing spreads and more from the price of gold. The distinction between B and C-rated junk bonds may be surprising but Ranson’s research has shown that while they are correlated to each other, C’s are much better correlated to the gold price while B’s correlate more to credit spreads.

The compass had nothing listed for north (weakening growth and heightened risk perceptions). Ranson noted that he was not aware of an asset class that would fit well in this slot but, like a gap in the periodic table of the elements, he could describe the attributes he expected it to exhibit. It would have to respond positively to widening credit spreads, and be little effected by the price of gold (or value of the dollar).

In response to a question following his presentation, Ranson pointed out that the correlations his model depends on often take several years to manifest themselves, so the model works best for patient investors with very long investment horizons.

CFA Society Chicago Book Club:

The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore by Michele Wucker

thegrayrhino-3D-coverOverlooking or underestimating obvious dangers is a timeless tradition. A man is terrified of planes but gets in his car every day and drives with no seat belt. A woman pays the fire insurance premium on her home religiously but doesn’t floss her teeth. People play the lotto but don’t take advantage of their employers’ 401(k) matching contributions. Organizations, including governments, are as bad or worse.  Passengers remove their shoes at airports to prevent a shoe bombing, which has been attempted once in human history—unsuccessfully—while infrastructure is allowed to crumble to the point of collapse, such as the I-35W Bridge in Minneapolis, Minnesota, that collapsed under the weight of normal traffic and killed 13 people. That catastrophe didn’t occur because it was rare, hard to predict or even unpredictable, a black swan in modern parlance from Nassim Nicholas Taleb’s 2007 classic of the same name.  Instead, those dangers are obvious and imminent; much like the danger of a charging gray rhino, from which Michele Wucker’s The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore (2016) derives its name.

In February of 2017, the CFA Society Chicago’s Book Club had the privilege of hosting Ms. Wucker in person to discuss her Book. The conversation was wide ranging and included water shortages, global warming, the Challenger Shuttle disaster, and many other topics. Why do we spend resources worrying about and preventing rare events but ignore or do nothing about obvious, preventable dangers? Ms. Wucker has several explanations from the social sciences: taboos about raising alarms, groupthink, anchoring and confirmation biases. She notes the origins of the sobriquet Cassandra, an unflattering term used to describe people who warn others about potential dangers. The original Cassandra was given the power of prophecy from the god Apollo. When she didn’t reciprocate Apollo’s affections, he threw a curse on her that prevented others from believing her prophecies, including her prophecy that the Greeks would attack Troy, which is what ultimately happened. The negative connotations that are associated with the name of someone who correctly warned others about impending danger speaks to deep seated cultural aversions to raising alarms. That negativity combined with the fact that Cassandra was a woman who was punished for shunning the advances of a male superior is a similarly depressing statement about society.

With the manifold existence of Gray Rhinos and their causes firmly established, the question turns to their taxonomy and life-cycle. Ms. Wucker identifies eight types and five stages of a Gray Rhino.  The eight types include the “Inconvenient Truth” Gray Rhinos that are widely recognized but not acted upon due to denial, including manufactured denial, and high costs to fix.  Global warming is the classic example of an Inconvenient Truth Gray Rhino. There are also the “Creative Destruction” Gray Rhinos such as Kodachrome, where acceptance and orderly unwinding are the only tenable solutions. It was not mama but the inevitable march of time that took our Kodachrome away. For each of the eight types in the taxonomy, all follow a life cycle of five stages. The first stage is denial, the second is muddling or kicking the can down the road, followed by haphazard diagnostic exercises, the third, panic, the fourth, and finally action.

Ms. Wucker’s Taxonomy and Stages are invaluable contributions to the ongoing policy discussion. The Taxonomy and Stages also need to be viewed in the context of organizational motivations and individual incentives, though. A good example is the Challenger disaster that Ms. Wucker opens her book with.  When making go/no-go decisions, it’s helpful to look at data from previous failures as well as data from previous successes. Space shuttles relied on re-usable solid rocket boosters for their initial launch. The boosters were built in segments and each segment had o-rings that were supposed to keep hot gas from escaping. When o-rings get too cold, they become brittle and fail allowing hot gasses to escape, which is what caused the Challenger disaster. On the morning of the launch, one engineer spoke up against the launch. The coldest successful launch took place when the temperature was 53 degrees. In that launch, gas escaped passed the first ring and caused corrosion on the backup ring, but the backup ring contained the gases. Below 53 degrees, there were no data. On the morning of the Challenger launch, the temperature was 35 degrees.

On January 28, 1986, NASA got an additional data point. The backup ring failed and seven astronauts died.  The Challenger disaster didn’t happen because the world’s smartest people didn’t understand the threat of cold weather to the proper function of o-rings. It happened because of the tremendous pressures on NASA to proceed with the launch. The space shuttle was originally conceived as a way to easily and cheaply launch people into space and return them in a re-usable ship.  The term “space bus” was even used. In practice, the program proved to be more costly and inefficient than the shuttle’s predecessors. NASA was under tremendous pressure to demonstrate the viability of the program.  In addition, the Challenger was going to launch the first teacher, Christa McAuliffe, into space. Millions of people were tuned to their television sets to see a launch that had already been delayed several times.  The organizational and public relations pressure to proceed with the launch overwhelmed good judgement.

Organizational pressures and incentive structures are that root of several Gray Rhinos. Scarce public funds either can be used to pay teachers or fix bridges that seem to work fine (until they don’t). Publicly traded companies struggle to look past obstacles beyond meeting quarterly numbers. Politicians aren’t incentivized to deal with any problem such as global warming whose most detrimental effects are likely to occur after a two, four, or six year term.

The assembled Book Club members and Ms. Wucker did offer several solutions to the Gray Rhino problem.  First, align incentives. Executive compensation should vest fully over a period of years or even decades.  Investors should similarly hold companies to account for long term performance and be more forgiving of short term volatility. Allowing US banks to hold stocks as banks do in Japan and Germany might allow more steady capital into capital markets and reward longer term performance, too. Second, break the problem into small pieces. There’s an old expression: “How do you eat an elephant? One bite at a time.” The same logic applies to Rhinos. Instead of trying to fix all the nations crumbling infrastructure, prioritize. Fix one bridge at a time, starting with the most dilapidated. Third, to combat groupthink and denial, include diverse perspectives in one’s circle and allow multiple channels of access to leaders and decision makers.  Related to that third point, the group discussed the competing leadership styles of Presidents Reagan and Kennedy. President Kennedy’s administration followed a spokes-on-a-wheel format where multiple influencers had direct access to the President, which could explain his successful resolution of the Cuban Missile Crisis. President Reagan, on the other hand, had a more linear chain of command with multiple bottlenecks and chokepoints, which could explain how in the Iran-Contra Affair a few rogue elements of his administration where able to conduct arms sales and a covert war without knowledge or involvement from either the State or Defense Departments.

The Gray Rhino is a welcome addition to current policy debates and compliments established organizational behavior and social science literature well. At 304 pages, it’s also a manageable and enjoyable read. The Society is very grateful to Ms. Wucker for her book and for her attendance at our meeting.

Distinguished Speaker Series: Richard Driehaus, Driehaus Capital Management LLC

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The Distinguished Speaker Series hosted Richard H. Driehaus at the Metropolitan Club Oak Room on March 1st, 2017. Mr. Driehaus is founder, chief investment officer and chairman of Driehaus Capital Management LLC. In 2000 he was named to Barron’s “All-Century” team whose players were deemed the most influential in the mutual fund industry over the past 100 years. Mr. Driehaus aim was to divide his presentation into three sections: Early Years, Investing, and Industry Trends.

DSC_3548He began his presentation by referencing the difficulties his father had in developing a residential lot his family owned. Although his father had a steady paycheck as a mechanical engineer, he was not able to afford his goal of developing the land for his expanding family. Mr. Driehaus at that point began thinking about how he would make sure to achieve his goals.

When he was 13, Mr. Driehaus spotted the NYSE quotes in a local newspaper. DSC_3533When informed about what the NYSE quotes meant, he became fascinated and soon found that his calling was the investment industry.

Mr. Driehaus argues that the principals of Taoism are applicable to the stock market. Taoism stresses living in harmony with the universal laws of nature. Nature has given man both a creative and analytic side to his brain. You must be able to use both sides of your brain to understand the market.

Mr. Driehaus shared the following market insights:

  • Stock price will almost always never equal a company’s intrinsic value. The valuation process is flawed.
  • It is better to concentrate in sectors as certain sectors will have better outlooks than the market as a whole.
  • More money is made by buying high and selling higher (positive relative strength).
  • Hit home runs, not singles and avoid striking out (cut your losses).
  • High turnover reduces risk; take a series of small losses but not a big loss.
  • Standard deviation is a poor measure of investment risk.
  • The greatest long term risk is not having enough exposure to risk.

Mr. Driehaus emphasized that continuous observation is needed for investment analysis.  Knowledge gained must then be applied in the context of a rapidly changing environment. You must maintain belief in your core principles for the long-term to succeed.

DSC_3541Mr. Driehaus had the following observations of the industry and current equity market:

  • A 60/40 equity/bond allocation will not be aggressive enough for retirees due to longer life spans.
  • As inflation becomes hotter bonds will be less attractive than stocks.
  • Active managers have been losing assets due to the lower fees associated with indexing.
  • Meaningful alpha generation is not easy in this environment but still doable.
  • Active management will outperform when interest rates normalize as equity dispersion will be greater.
  • Expect a greater shift to international equities.

Following his presentation Mr. Driehaus fielded questions on a number of topics:

  • Investing in growth stocks allowed him to prove himself more quickly.
  • Hedge funds are paralyzed because they want safety; they are not taking on enough risk to differentiate themselves.
  • Look closely at volume when you’re thinking about selling one of your winners.
  • His philanthropy emphasizes that architecture is very important. Big box retail has killed a number of small communities and failed to protect the “sense of place”.