View photos from the 28th Annual CFA Society Chicago Dinner, held on Oct. 23, 2014, at the Navy Pier Grand Ballroom in Chicago.
Claritas is a Latin word which in English denotes clarity or brightness. The CFA Institute began the Claritas Investment Certificate as a global education program designed to give a clear understanding of the essentials of the investment industry. This program is geared toward all professional disciplines not including those who are investment decision makers. There are no education or experience requirements needed to enroll.
On Sept. 10, 2014, CFA Society Chicago kicked off the Claritas Prep Program. The program is being taught by the following instructors:
Michael Falk, CFA – Falk is a partner at Focus Consulting Group and teaches as an adjunct professor at DePaul University in their Certified Financial Planner program.
Joseph Vu, Ph.D, CFA – Vu is an associate professor of finance at DePaul University, he has also taught at the University of Chicago.
Andrew Kominik, CFA – Kominik joined William Blair & Co in 2003, his current role is as a quantitative portfolio analyst serving equity management teams.
Brian Langenberg, CFA – Langenberg serves on the Career Management Advisory Committee and is adjunct professor of finance at Southern New Hampshire University.
There were approximately 40 participants gathered for the first class who were welcomed by Michael Falk, CFA. Falk had prepared 70 slides to cover the first four chapters (Module 1) of the prep course. The CFA Chicago Fundamentals of Investing Course has been adapted and used as a guide for developing the new Claritas Prep Program. Each candidate is supplied with an e-book and hard copy of the instructors’ presentation.
The course will be 7 weeks in length and consist of 7 modules (2-4 chapters) followed by a mock exam on the 8th week. The 7 modules aim to cover the essential characteristics of all aspects of the investment industry. It is estimated that 80-100 hours of study will be required over a 3-6 month period to prepare for a 2-hour multiple choice exam.
The successful completion of the course and the attainment of the certificate will benefit both the employee and the employer. The shared understanding of the “big picture” will improve performance of investment teams. Holders of the Claritas Investment Certificate will attain knowledge above their peers and demonstrate a commitment to the industry.
CFA Society Chicago hosted approximately 140 people at the University Club of Chicago overlooking Millennium Park on Sept. 23, 2014, to discuss energy investment opportunities at a thought-provoking conference entitled “A Seismic Shift: The Changing Dynamics of the Global Energy Scene.” I served on the planning committee for this event and can tell you that we were thrilled to have two panels of experts who provided insights ranging from global, macroeconomic and geopolitical energy issues all the way down to sector-specific investment ideas across the energy value chain. The dramatic increase in U.S. proved oil and gas reserves due to fracking is expected to drive a reindustrialization of North America. It should be noted that the panelists did not provide specific recommendations to buy or sell particular securities or provide investment advice.
Douglas Brown, Senior Vice President and Chief Investment Officer of Exelon Corporation (EXC) and CFA Chicago Board Member, gave a warm welcome to the attendees and emphasized that this is an important time of energy transformation for North America. Tim Greening, formerly Managing Director at Fitch Ratings, moderated our first panel discussion with Olga Bitel,Portfolio Strategist at William Blair, Rachel Bronson, Senior Fellow for Global Energy at The Chicago Council on Global Affairs and Jan Kalicki, Public Policy Scholar at the Woodrow Wilson International Center. Read more about all of our panelists here.
Geopolitical and Macroeconomic Issues (Panel 1)
The energy environment is in a state of revolution.
Jan Kalicki, Public Policy Scholar at the Woodrow Wilson International Center, started the program out at a sweltering pace by announcing that the “energy environment is in a state of revolution” as world energy production is shifting from the Middle East to North America. Drawing from his published expertise on “Energy and Security: Strategies for a World in Transition,” he quickly pointed out that the newfound oil and gas supplies in the United States has made the country more energy secure but not necessarily “energy independent.” Rather, it’s better to use the term “energy interdependence” to describe today’s situation because energy is a global commodity and the idea of energy isolationism is an illusion. Kalicki pointed out that the U.S. still needs to develop a national and global energy strategy that should include “free trade in energy” like LNG exports to Japan while noting that Japan does not have a Free Trade Agreement (FTA) with the United States. Furthermore, 85% of the Outer Continental Shelf still remains off limits for development. He stated that the Keystone XL Pipeline Project by TransCanada (TRP) is a good idea for the U.S., safer and more effective than attempting to ship oil by railcar and a better alternative than allowing it to go to other markets abroad. The shale plays in the U.S. have been successfully developed by private, rather than governmental, investment and the U.S. is now at a competitive advantage to other nations with less favorable land use/access policies for energy development. Finally, Kalicki noted that Russia is facing a major threat of economic recession and huge flights of human and financial capital. GazProm is the largest energy monopoly in the world and only recently has the European Union begun to move against it. Also, Eastern Europe remains far more susceptible to gas shortages from Russia than Western Europe.
A global disruptive energy boom will drive economic growth where resources are exploited.
As an economist, Olga Bitel, Portfolio Strategist at William Blair, quickly pointed out that economic growth is always subject to resource constraints. A decade ago horizontal drilling and fracking in North America was just getting started but through a favorable regulatory regime and “lucky” geology the U.S. is experiencing an unprecedented energy boom which will eventually be a global phenomenon that will affect every country in the world. Secondly, there have been continuous changes in renewable energy technology that will be just as disruptive to energy markets as we’ve seen with fracking. Thirdly, people are actually starting to talk about decarbonization of the global economy. On environmental issues, Bitel emphasized that they are far too important to ignore – especially as it relates to coal usage and the health issues associated with air pollution. She explained that the market will eventually find a way for the energy to flow – even if it’s not along an optimal path. Therefore, it’s important to get the regulation right on things like the Keystone XL Pipeline project where a pipeline through relatively unpopulated areas would be a safer alternative than railcar transportation. Bitel believes the environmental issues associated with fracking (water pollution, etc.) can be properly resolved with the right regulation and protections when properly considering the economic costs and benefits. Finally, Bitel made a variety of points regarding energy markets, prices and trade including:
LNG: The U.S. has gone from contemplating more LNG import facilities to approving LNG export terminals. This wasn’t in anybody’s playbook a decade ago. The approval of U.S. LNG exports was so significant that it was felt in foreign exchange markets!
Natural Gas: Geology and water access issues may delay development across the globe but China and other parts of the world will develop new gas resources this decade. BASF has announced plans to invest in a specialties chemicals plant in Louisiana which demonstrates the market’s view that natural gas prices will be cheaper in the U.S. for a considerable period of time. And that the U.S. is the best place to make significant energy investments. Yet, gas prices will eventually start to move closer to a more central world market price as time goes on … in the 3, 5 or 10-year time frame.
Renewables: Wind and solar power are commercially available and costs on par with fossil fuel energy. It’s not just being developed in the desert anymore. Germany is producing 20% of their electricity from wind today and Denmark has been exporting energy for a decade. During the first six months of 2014 the U.S. has seen tremendous growth in new utility-scale solar ad renewable power development.
Source: U.S. Energy Information Administration, Electric Power Monthly, August 2014 edition with June 2014 data
Note: Data include facilities with a net summer capacity of 1 MW and above only.
Oil: About 80% of net new oil production compensates for the decline in field production alone while only 20% provides for new demand. Therefore, each new oil well costs more to develop. Globally, risks in Argentina and Venezuela continue to be significant where assets could be confiscated on a dime. Oil prices are expected to be broadly stable and declining in real terms.
Utilities: The utility industry has been about as stable and staid as you can get for the last 100 years with a regulatory environment that is still stuck in first part of 20th century. There is no forward-thinking regulatory policy in Germany and Japan at this time. We need a new electricity market to properly compensate for different and changing sources of electricity. If we get this right, then the required investment will come forward.
U.S. Dollar: The U.S. dollar is the global reserve currency and the source of global liquidity. We’ve seen lower levels of U.S. dollars flowing abroad, and a lower current account deficit, because energy imports are shrinking quite rapidly and over the next three years the U.S. will begin exporting LNG. In light of fewer dollars flowing out of the country there will be a higher premium for U.S. dollars that will lead to a rising value of the dollar. The energy boom will create more stable oil and commodity prices globally. As monetary conditions tighten, the Federal Reserve may not have to move as fast on increasing interest rates due to the reduced impact of energy on inflation.
The geopolitics of energy is changing on a daily basis.
Rachel Bronson, Senior Fellow for Global Energy at The Chicago Council on Global Affairs, is an expert on energy issues in the Middle East and author of “Thicker than Oil – America’s Uneasy Partnership with Saudi Arabia.” She emphasized that changing energy geopolitics are everywhere in the press today. Examples include, territorial disputes between China and Vietnam in the South China Sea, driven by potential oil and gas under the waters, and ISIS capturing oil resources in Iraq and selling it on the black market. Nations throughout the world are now aggressively seeking access to energy resources. China’s huge demand for energy and air quality problems are driving its energy resource development. Although Russia can meet a lot of Chinese demand, the Chinese are trying to make themselves as self-reliant as possible and seem to be managing it quite well. China’s demand is so large that it will be importing coal for a long time and it remains to be seen who else would be willing to finance infrastructure in China – other than the Chinese. Poorer countries, like Morocco, are developing new energy resources to make them more economically competitive by exploiting their solar resources, reducing energy imports and possibly exporting energy in the future. The energy landscape continues to change dramatically across the globe as the U.S. moves from being an energy consumer to a producer, China transitions from an energy exporter to an importer and Israel develops new resources in the Mediterranean Sea.
Bronson also emphasized that the U.S. is more energy secure but not energy independent. Although there are 3 million more barrels of oil going on the market per day from new resources the market has lost just as much from political turmoil in other parts of the world. Even if oil from the Middle East doesn’t flow to the U.S. it will flow to Asia and the Middle East will remain a strategically important place in the energy landscape. For example, Saudi Arabia has been the global “swing producer” of oil because it doesn’t produce to capacity and has been able to put more oil on the market in response to a crisis. But if, for some reason, Saudi Arabia can no longer play this role as the swing producer (i.e. due to the lack of a smooth political transition, etc.) oil prices could still shoot to $200 per barrel.
Bronson concluded with a sobering warning on the riskiness of Germany’s huge bet to transform its economic base through its tremendous shift to renewable energy sources and a more climate-sensitive economy. She indicated that we should be paying daily attention to Germany’s energy plan because if it doesn’t work then it could pull down the German economy and much of Europe as well. The problems include the fact that the energy resources are far away from the demand centers and Germany lacks the infrastructure to get the energy to where it’s needed. In addition, electric prices in Germany are currently twice the cost of the U.S. and that may push more energy intensive companies out of the country. As Germany attempts to replace its nuclear power resources with renewables it’s incurring huge costs, with no guarantee of a reliable outcome, and increasing its reliance on coal. Japan is wresting with the same issue in a country where they rely on energy imports for over 90% of their demand and finding that it’s very difficult to turn off the nuclear plants.
Investment Opportunities Across the Energy Value Chain (Panel 2)
Herve Wilczynski, Partner at A.T. Kearney in Houston with over 20 years of oil and gas experience, moderated the second panel and transitioned the discussion from the geopolitical and macroeconomic environment to sector-specific investment ideas. Wilczynski underscored the magnitude of the shift in energy to North America with the fact that Exxon/Mobil, one of the global super majors, is relocating its headquarters to a massive facility in The Woodlands near Houston, Texas. He observed that it’s hard to image that on April 5, 2005 Federal Reserve Chairman Alan Greenspan said, “North America’s limited capacity to import liquefied natural gas (LNG) has effectively restricted our access to the world’s abundant gas supplies.” And today the U.S. is playing in a global energy world with Russia and Qatar. Wilczynski introduced the members of Panel 2 which were Mr. Mark Ermano, Vice President Chemical Market Insights at IHS Chemcial, Mr. Terry Smith CFA, Executive Director, Head of Credit Research – Americas at UBS Global Asset Management, Mr. Anthony “Tony” Lindsay P.E., R&D Director – Advanced Energy Systems Group – Gas Technology Institute (GTI) and Mr. Ron Mullenkamp CFA, a professional investment manager and founder of Mullenkamp & Company, Inc. The panel probed the factors that could impact the sustainability of the U.S. energy revolution including regulatory, infrastructure, labor shortages, etc. and were generally bullish about the the prospect of significant demand growth in areas like chemicals, transportation, power generation and a number of other areas noted below.
Base chemicals and plastics drive a renaissance in U.S. manufacturing
Mark Ermano, Vice President Chemical Markets Insights at IHS Chemical, quickly made the connection to our day-to-day lives on the “far right hand side of the energy value chain” and explained that chemical industry is producing plastics which enable modern living through thousands of durable and non-durable goods like cars, phones, trash bags, etc. all derived from energy feedstocks on the left side of the energy value chain such as oil, natural gas, coal or biomass which are transformed into different chemicals and eventually into the retail goods we use every day.
The energy revolution has created a North American manufacturing renaissance in the United States. Chemical plants require three basic things to beat the competition. First, access to a low cost Btu feedstock for a long period of time that allows the plant to earn its return on and of capital. Importantly, the cost of new refining or derivative complexes can range from $20 million to $50 million per plant. Second, locating new plants where demand is growing the fastest reduces logistics costs and provides a competitive advantage. Third, use of the right chemical manufacturing technology provides a competitive advantage. BASF’s announcement that they will not use steam cracking but go directly from natural gas to propylene in a world-scale methane-to-propylene complex in the U.S., which requires three times the conventional investment, clearly demonstrates their favorable long-term market view of U.S. natural gas supplies and pricing.
Today, due to the abundant new supplies of low cost natural gas in the United States, we are seeing a massive wave of new investment in the U.S. petrochemical industry to bring new capacity on line in the 2015-2020 timeframe. Previously, the petrochemical industry was building abroad and the U.S. had not added a new cracker since 2000. However, we now expect to see an ethylene-based cracker built in the United States by the end of 2015. These investments will require huge amounts of basic infrastructure, labor, iron, ironworkers, welders, electricians, etc. Furthermore, since demand in the U.S. market is forecasted to be relatively stable most of the new products derived from these chemicals will be exported and new infrastructure companies will be needed to support that function. China’s emerging middle class is expected to reach the purchasing power of the U.S. consumer in the next 5, 10 or 15 years and other emerging economies will drive demand. Finally, watch for new foreign flows of investment capital into the U.S. chemical market.
Potential Winners: Midstream companies. Feedstock companies. North American fundamental gas, ethane and chemical derivatives manufacturers – now seeing the highest levels of profits ever experienced as higher-cost producers abroad set the price and low-cost U.S. producers extract high levels of margin in that chain. Winners may include base chemicals and plastics manufacturers like BASF and SABIC. Also, infrastructure providers, pipe, valves, iron, welders, electricians, etc.
U.S. energy infrastructure expands in many directions…
Terry Smith CFA, Executive Director, Head of Credit Research – Americas at UBS Global Asset Management, believes that North America will have an economic advantage from shale gas for at least the next two decades. Furthermore, the U.S. will be in a position to export its shale gas/oil intellectual property, engineers, patents and designs to the rest of the world. He sees more natural gas liquids (NGL) fractionation plants being built and noted that there are 14 new LNG facilities currently being planned.
This reindustrialization of North America drives demand for everything from infrastructure and labor to chemicals, coatings, and technology start-ups unrelated to IT. And many of those workers buy new pickup trucks, which boosts the auto industry, as well. Solar and wind farms also benefit from low cost natural gas prices because these facilities need a reliable source of backup power from a combined cycle gas turbine. The transportation sector will see more long-haul trucking converted to LNG while ethanol producers may transition to isobutenol as an oxygenator. Smith suggests that water handling will be an area of enormous opportunity due to the amount of water necessary for fracking and the difficulty to transport this amount of water by truck which could lead to new long-haul fresh water pipelines. And more water will also be needed to clean the solar panels and wind turbines. That revolution in water technology will also provide a boost to agriculture, and to potable water for cities and industry. Finally, Smith observes that most of the new solutions will not eliminate the others so investment analysts should focus their research on the cost/benefit of the opportunity, the market size and the competition.
Potential Winners: Wind and solar farms. Combined-cycle gas turbines. Natural gas liquids (propane, butane, ethane, etc.). U.S infrastructure and labor providers. LNG tank manufacturers for long-haul transportation (tanks, valves, hoses, etc.), LNG for locomotive engines, tugs, barges and ferries. Increasing demand for carbon fiber. Water handling and transportation.
The third time’s a charm … natural gas as a transportation fuel.
Anthony “Tony” Lindsay P.E., R&D Director – Advanced Energy Systems Group – Gas Technology Institute (GTI), explained that the U.S. is currently in its third major “wave” of developing natural gas as a transportation fuel. The first wave occurred as a result of the perceived oil shortages in the mid 1970s and some new natural gas vehicle products were developed at that time. However, when gasoline prices dropped, the wind was taken out of the sails of the first wave. The second wave was driven by two key pieces of U.S. legislation: the Clean Air Act Amendment (CAA) of 1990 and the Energy Policy Act of 1992 (EPACT-92). The tighter vehicle emissions standards of the CAA led the big three automakers to produce a number of new natural gas vehicle offerings including the Ford Crown Victoria, F-150 pickup trucks, cargo and passenger vans, Chevy Cavalier, pick-ups and full-size vans, and Chrysler also introduced its B-series vans for compressed natural gas (CNG). In addition, the EPACT-92 mandated certain fleets of vehicles to switch from gasoline or diesel to alternative non-petroleum energy sources like natural gas. However, the legislation lacked significant penalties, there was not much “pull” from fleet owners because the economics were only marginal, and the second wave also crashed to the shore. Today, we’re in the third wave and Lindsay believes it’s a “perfect storm” for natural gas vehicles (NGVs) because the economics are favorable, environmental concern is high and the U.S. has an abundant, low-cost supply of natural gas from the shale revolution that can finally provide the U.S. with the energy security that was previously lacking.
Lindsay explained that approximately 26% of the energy consumed in the United States each year is from natural gas. And the U.S. uses approximately 95 quads (quadrillion BTUs) of energy per year. Yet, the transportation sector uses less than 1% in vehicles (which is only about 140,000 natural gas powered vehicles) while the top five nations using natural gas vehicles are Iran, Pakistan, Argentina, Brazil and India, each with over 1 million NGVs on their roads! After evaluating the U.S. NGV market, Mr. Lindsay believes that high-usage, heavy-duty vehicles represent the best opportunity for near-term growth because these vehicles consume from 5,000 to 30,000 gallons of fuel per year and that produces enough savings to justify the incremental vehicle and fueling investment cost thereby creating a 1.3 Tcf/yr growing market for gas as a transportation fuel. Notably, Waste Management’s (WM) fleet of about 1,700 CNG and LNG vehicles is the largest in the waste industry. Although the light-duty car and truck market is as large as 16 Tcf/year those vehicles typically consume only about 1,000 gallons per year and the U.S. currently lacks a robust compressed natural gas refueling infrastructure to conveniently support them. However, if a low-cost natural gas home refueling device could be developed then it may be a significant game changer in the light-duty market.
Potential Winners: Refuse haulers, cement mixers, regional fleets with the ability to refuel at a central location, fleets of taxis serving airports, CNG/LNG storage tank manufacturers and those that make the materials that go into the tanks, lighter weight higher strength composite cylinders with carbon fiber wrap, high pressure gas components, hoses, fittings, meters and valves. Manufacturers of heat exchangers used in the LNG industry as well as engine manufacturers serving medium and heavy-duty truck applications.
Natural Gas: An Energy Game Changer
Ron Muhlenkamp CFA, a professional investment manager, founder of Muhlenkamp & Company, Inc. and author of “Ron’s Road to Wealth: Insights for the Curious Investor,” provided an astounding range of perspectives from his experience as a farmer, investor, engineer (M.I.T) and Harvard M.B.A. Mr. Muhlenkamp’s farm sits directly on top of the Marcellus Shale in Butler County, Pennsylvania and he began by providing the audience a real education on natural gas from his booklet entitled “Natural Gas: An Energy Game Changer”
First, in Figure 1 below, he points out that natural gas has been priced significantly below crude oil on an equivalent price per MMBtu basis since 2009. This dramatic divergence in price is huge since the two have been fairly close on a $/MMBtu basis since 1995. While many in the Northeast still heat their homes with oil those who have converted to natural gas are now realizing significant savings due to the availability of low cost natural gas.
Figure 1 Natural Gas and Crude Oil Prices, 1995-2013
Source: Bloomberg; Oil; Generic 1 ‘CO’ Future, Natural Gas; Generic 1 ‘NG” Future delivery to Henry Hub
Second, in Figure 4 below, he shows the steadily increasing use of natural gas for U.S. electric generation since 1996 and the corresponding decline in the use of coal-fired generation. Utilities switch from coal to gas-fired generation at about $3.00 per Mcf so more access to lower-cost gas supplies reduces both home heating costs and electric bills.
Figure 4 Percent of Total U.S. Electricity Net Generation: Electric Power Sector by Energy Source, 1960–2012
Source: U.S. Energy Information Administration; Electric Power Monthly. Table 7.2b and 8.2b
Third, Figure 5 shows that Barnett Shale fracturing began in 1997, Marcellus shale in 2005 and Bakken Shale in 2008. Importantly, U.S. oil and dry natural gas proved reserves began increasing dramatically after these events reaching 29 Tcf of gas and almost 27 (bnb) billion new barrels by 2011. Muhlenkamp notes that the U.S will be drilling the Marcellus Shale for a long time and in fact has more supply than available pipeline takeaway capacity to deliver it to New England. Bottom line, the last five years have been an energy game changer!
Figure 5 U.S. Oil and Dry Natural Gas Proved Reserves, 1979-2011
From an environmental standpoint, Mr. Muhlenkamp points out that by switching from coal to natural gas the carbon content of the fuel source is cut by more than 50%. From a land use perspective, if we consider the fact that 80 windmills are equivalent to about 10 gas wells then wind farms are not be as “clean” as we might think. In addition, although fracking requires significant amounts of water most people don’t know that burning 1 Mcf of natural gas produces 11 gallons of fresh water in vapor form. Mullenkamp turns the equation on its head by stating that by burning natural gas you produce fresh water at 8 cents/gallon and you get the energy for free. Going further, if you use salt water for fracking (subject to salinity limits in the wells) the well effectively becomes a desalinization plant. Agreeing with many of the other speakers, Mr. Muhlenkamp also believes we are taking a step “backward” when we produce fuel (ethanol) from food (corn) since historically farmers increased food production only after moving from horses (which required acreage to feed them) to tractors.
Potential Winners: Natural gas pipelines. Labor markets where skills to work in the oil and gas industry can be acquired in 12 to 18 months at junior colleges. Natural gas consumers – benefiting from prices at $3.00 to $5.00 Mcf but putting pressure on producers where break even is at about $3.00 per Mcf. Producers benefiting by drilling horizontally 5 to 8 times, in different directions, from the same gas pad saving approximately $500,000 per well. Also see p. 52 of “Natural Gas: An Energy Game Changer.“
Let me begin with a thank you to CFA Chicago’s Governance & Nominating Committee for entrusting me with the role of Chairman. It’s a distinct honor to lead the oldest Investment Analyst Society in the world. Positioning our 89-year-old brand for the future, delivering relevant and cutting-edge programming, and enhancing member value are our top priorities.
As our board and officer volunteers change annually, I have worked extensively with our Vice Chair Kerry Jordan, CFA, to create a long-term vision for our enterprise. Kerry and I are just back from a CFA Institute Society Leaders Conference in London where best practices and future opportunities for our profession were exchanged. The key takeaways from London for me are: the U.S. asset management business is very dynamic and mature, and globalization remains apace at an increasing rate.
With respect to international financial services and investing, the five newest Societies in the CFA Institute family are Qatar, Norway, Peru, Lichtenstein, and East Africa. And while the U.S. base of Charterholders remains the core membership, the candidate population and growth rates in international markets are much higher, and more diverse, than in the United States.
As I write this, the Chinese e-commerce firm Alibaba’s IPO is set to price this evening. On a market cap basis, four of the top 10 internet companies will be based in Asia, up from two in 2004. One of my London partners said this is evidence of “China’s capitalistic system writ large.” We are an international profession and we must continue to think globally.
Our Society is positioned quite well with 4,300 members, talented volunteers, dedicated staff, and because of thoughtful stewardship, strong financial resources. Resting on our laurels, however, is not what Kerry and I and the board can or will do. As the 6th largest and original Society, we must be strategic about our industryand what role Chicago’s financial services community and professionals will play as we move toward our 90th year and beyond. Thankfully, our leadership team and board are embracing the challenges we face in this dynamic environment.
Lastly, let me express great appreciation for an outstanding membership. Your time, energy, ideas, and ethical practices are the most valuable asset we have. Please get involved, stay committed, and then recruit a fellow professional to take your place in the future. I hope to see you at our annual dinner in October.
Nicknamed “Super Mario” by financial media pundits, Mario Gabelli, CFA , Chairman and Chief Executive Officer of GAMCO Investors, Inc., presented his ideas on shareholder activism to a sold out crowd at the University Club on Aug. 12, 2014.
The idea that activists are catalysts was center to this Charterholder’s presentation. Teeing up that idea, he gave us insight into the philosophy and investment thesis that GAMCO follows with several quotes: “If you drink it, we follow it, and if you watch it anywhere, we follow the content”. What and who have influenced him? He noted Graham and Dodd and Security Analysis as being the definition of value investing and Roger Murray, his professor at Columbia Business School as having a large influence on his decision to go into investment management. Gabelli’s unique sense of humor bubbled through as he compared Mount Rushmore to the four professors who created value investing.
Given these influences, his investment process is very similar to what Graham and Dodd taught in the 1930s. So, what twist does Gabelli put on value investing? He looks at private market value – intrinsic value plus a control premium with a catalyst. Catalysts bring underlying value to the surface and include regulatory changes, industry consolidations, death of a founder, share repurchases, division sales, management succession and finally, shareholder activism.
Activist hedge funds net asset inflows were 5.3 billion in 2013 with 59% of activist objectives achieved in 2013. Gabelli walked us through various models of shareholder activism touching on big names and big results such as Carl Ichahn, Jeff Ubben, George Hall and David Einhorn. He pointed out that Carl Ichahn’s model works because there is demand for it. When discussing shareholder rights and the “poison pill”, Gabelli advocated that GAMCO votes against it per their Magna Carta of shareholder rights. After all, it is all about the shareholders who own the company.
The presentation wrapped up with a discussion of companies in our own Chicagoland backyard who have either split and created value or have the potential to create value with a split. As a final nugget of wisdom before the Q&A, Gabelli recommended The Graduate as an important movie because as you watch a young Dustin Hoffman receiving advice on what he should do with his career, you realize this is defined the attitude of people in the ‘60s or ‘70s. What movie will define the times we are living now?
An intrepid group of approximately 50 seafaring CFA Chicago members and guests boarded the Tall Ship Windy at Navy Pier for a memorable evening architectural tour of the Chicago skyline and networking voyage on July, 22, 2014. The event was hosted by the Social Advisory Group.
The Windy is the only 148-foot traditional four-masted gaff topsail “pirate” ship in Chicago. Before departing, our pirate guide “Trooper” informed all passengers of the safety precautions and enforcement policy …“No smoking or you will be thrown overboard!” And then, he competently guided the tour, which lasted just over one hour, from Navy Pier to the Adler Planetarium (and back) while providing an entertaining history of Chicago and its architecture including both legend and lore.
Trooper began by asking the passengers about the cause of the Great Chicago Fire that lasted from October 8, 1871 to October 10, 1871. Although Mrs. O’Leary’s cow came to mind for most, even before cocktails, Trooper explained that the reporter who wrote the O’Leary account later admitted he made it up as colorful copy and the City of Chicago exonerated Ms. O’Leary in 1997. Half way through the voyage the crew suddenly shouted “Prepare to Jibe! Prepare to Jibe!” and relayed that message all the way from the ship’s stern to its bow. Hearing this command, several CFA Charterholders instinctively thought it was time to bust out their best dance moves but soon realized they were just preparing to turn the boat (Oh, they said jibe – not jive). The jibe, opposite of the tack, is a turning maneuver in which the stern of the boat passes through the wind rather than the bow.
Trooper went on to explain that Chicago is called the “Second City” because it was rebuilt on the embers of the first city after the Chicago Fire by architects and designers like Louis Sullivan (“the father of skyscrapers”) and Daniel Burnham (City Planner and Director of Works for the World’s Columbian Exposition in Chicago 1893). He artfully told a number of stories about a variety of buildings including the 311 South Wacker Building (the crown was redesigned to be a replica of the wedding ring given to the architect’s fiancé), Willis Tower (elevators traveling 1,600 feet per minute are among the fastest in the world), John Hancock Center (its trapezoidal structure and legend inspiring Harold Ramis’s diabolical building in “Ghostbusters”) and Lake Pointe Tower (standing alone east of Lake Shore Drive) to mention a few. Overall, the voyage was smoother than a metra train commute and provided a fun and educational networking experience.
The Distinguished Speaker Series hosted Rick Rieder whose other duties include Chief Investment Officer of Fundamental Fixed Income for BlackRock and Chairman of the BlackRock Investment Council. BlackRock is the largest asset management firm, now managing over $4.3 trillion for clients worldwide. In 2013 Mr. Rieder was inducted into the Fixed Income Analyst Society Hall of Fame. He was introduced by James Franke, Co-Chair of CFA Chicago Distinguished Speaker Series Advisory Group.
Rieder’s presentation was entitled “The New Economic and Investment Regime”. His thesis is that economic forecasting and investing is now dependent on the following four critical factors; 1. Demographics, 2. Leverage, 3 Technology, and 4 Monetary Policy. He went on to demonstrate how each of these factors works to influence the economy and therefore interest rates. His thesis is that growth will be slow and the yield curve will continue to flatten.
Rather than simply alluding to an aging population, Rieder pointed out the employment problem and the financial burden of high student debt on the younger population. The demographics lead him to conclude that current consumption and spending trends will remain low. The implications of leverage in developed and emerging markets point to the continued availability of cheap financing. Rates in the US and UK could grind higher in the context of a flat yield curve. Rieder concluded that technology has created the biggest headwind against inflation and will continue to suppress levels of employment. With respect to monetary policy, Rieder points out that an important by-product has been that long-dated Treasuries have become scarce due to less supply needing to be issued, continued strong foreign buying and demand for long-dated assets from pension funds and insurance companies.
Rieder concluded by suggesting which asset classes have the best potential for appreciation. He strongly recommended long-dated municipal bonds as there is very little issuance. Short dated ABS and CLO’s are also attractive in this environment. Rieder is bullish on the equity market given the cheap financing presently available to corporations, he predicts this will persist.
There was a brief question and answer period following the presentation. On the question of what affect exiting QE might have on the capital markets, Rieder stated that although history says differently, he did not think a big equity sell-off would occur. In response to another question, he thought that high-yield was fundamentally sound and although there would be a pause, it would not suffer big outflows.
A provocative presentation entitled Conventional Wisdom and Pseudo-Science: Are we Blinded by Theory? took place in front of a sold out audience of 176 on June 19 at the Metropolitan Club. Rob Arnott, Chairman & CEO, Research Affiliates was the speaker who generously shared his unconventional thoughts in debunking several core theories of finance.
His objective was to take us on a whirlwind tour of areas where conventional wisdom can often lead one astray. The premise of Arnott’s talk is that much in the world of finance masquerades as science, but is not. When theory and data conflict the standard reflex is to dismiss the data.
In assuming that theory is correct, one must tacitly assume that all assumptions are correct. Unfortunately, assumptions are oftentimes incorrect, and is the cause of the fissures between theory and reality.
Almost every popular theory of finance can be debunked in some way based on a flaw in the assumptions required to make the theory work.
Efficient Markets, Miller-Modigliani, Modern Portfolio Theory, CAPM, Black Scholes, Cox-Ingersoll-Ross, Behavioral Finance, etc. –- they all can be taken down in an imperfect world where reality does not cooperate with the assumptions.
An easy example to refute the efficient market theory in the equity markets considers empirical data involving the Top Dog in a sector.
The Top Dog is ranked #1 by market capitalization in a sector, a market, a country, or the world.
To get to Top Dog status requires outperformance. Over the preceding 5 year period, the Top Dog in the US outperforms the broad market by 20%. A global Top Dog outperforms the average stock in the world market by an even more impressive 40% in the 5 years leading up to becoming the Top Dog.
Going forward one might expect equal performance by the Top Dog according to the Efficient Market theory. However, reality suggests underperformance. And not just a modest level of underperformance, data suggests the Top Dog underperforms the market vastly in the ensuing 5 year period. In fact, the entire gain that got them to Top Dog status is often given up as the Top Dogs generally deliver less than bonds and cash. Is this a peculiarity? Or simply evidence that markets are not as efficient as theory suggests?.
Arnott suggested that history could taken a different course. What if, instead of advancing efficient markets in 60’s, there was a promotion of deranged markets. The market is always missing and trying to mean revert? It would explain anomalies. What if a DAPM (disorderly asset pricing model) involving mean reversion was advanced? The Nobel Prize might have never been granted to William Sharpe for CAPM and his extension of Markowitz’s portfolio theory.
Refuting CAPM was an easy target as the theory assumes everyone on the planet can borrow or lend at the risk free rate while ignoring taxes and a host of other real factors. If all of the CAPM assumptions rang true, the theory proves you cannot beat a cap weighted market. Because the assumptions are not true, the conclusion of CAPM theory must be taken as only an approximation of fact.
Working backwards, the assumptions allow for the mathematics to work out. Do not make the mistake of believing the theory proves that is how the world ought to work. Rather, the theory is totally expected given the assumptions. When empirical gaps exist between data and theory, do not automatically assume the data is wrong or bend it in order to justify the theory. Just as important as knowing the theory is to perform a judicious search for gaps in the assumptions.
In summary, Arnott left the audience with a prudent message. Theories are wonderful, and it is not necessary to disregard theory. However, please do not confuse theory with fact. It is not.