Distinguished Speaker Series: David Herro, CFA, Harris Associates

Trust and effective communication provide investment teams with the ability to stick with a sound investment philosophy and process during periods when the approach is out of favor with the market. Oakmark’s focus on developing an intrinsic value for companies provides a foundation for portfolio management decisions. He believes that this foundation drives the long-term successful investment returns that the firm has earned for clients.

David Herro, CFA, partner, portfolio manager and chief investment officer of International Equity at Harris Associates, addressed 200 guests at the University Club on Tuesday, October 8th for the sold-out Distinguished Speaker Series luncheon. Herro emphasized the importance of our fiduciary duty, a sound investment philosophy, the difference between a business’s value and its stock price, the opportunities that macro events can create and the importance of managing emotions. These five themes have been central to his long-term success managing the Oakmark International Equity mutual fund.

Herro measures the attractiveness of a business based on the present value of expected free cash flow. Prices below this value create buying opportunities, and above a reason to sell or not buy. He uses a normalization process to determine the required discount rate, instead of using today’s very low rates. The discount rate also varies for countries and companies based on risk assessments. During his presentation, he illustrated times when one of his holdings, Glencore PLC’s stock price movied far from his computation of intrinsic value. He noted that price often responds to current information versus the long-term business value. This volatility provides opportunities for investors. He guides clients to think and act like investors, not traders.

Herro provided several examples of when macro events moved security prices far from intrinsic value. During the European sovereign-debt crisis investors could purchase Italian government bonds with yields near 8.0% that are less than 1% today. Additionally, yields on Greek government bonds moved above 30% in 2012 and are now lower than US Treasury yields. He notes that despite these movements in price, intrinsic values have not changed by these large magnitudes.

Managing emotions requires a strong foundation. The faith to maintain a set of beliefs during the great financials crisis eventually rewarded investors. In contract, a focus on stock price movement created severe anxiety that lead to many poor decisions.

Herro compared today’s difference between the performance of growth and value styles as comparable to the 1995 to 2000 timeframe. He acknowledges that identifying a change in this relative performance is extremely difficult due to a large number of variables with unstable coefficients. However, he believes that the magnitude of the differences strongly favors the value style currently.

Herro noted that we should never forget that our purpose is to earn returns for our clients. Key ingredients to success include a sound approach, acting like an investor vs. a trader, exploiting opportunities created by macro events and managing emotions. These thoughts have served him well and he believes that they will continue to serve our industry well.

Distinguished Speaker Series: Rob Brown, CEO, Lincoln International

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Distinguished Speaker Series: Vivien Azer, Cowen & Co.

Cowen’s Views on Cannabis

On July 9, Vivien Azer, the analyst responsible for covering cannabis at Cowen & Co., presented her views at CFA Society Chicago’s Distinguished Speaker Series luncheon at the University Club. Cannabis/Hemp/CBD is an “emerging” sector within the U.S. and Canadian stock markets as legalization of the formerly stigmatized substances has begun to change.

Azer concluded that the “relative size of mature Consumer Products Group (CPG) categories reflects a long runway for growth in cannabis”. The global size of the alcoholic beverage market is $1.3 trillion, the NARTD (non-alcoholic ready-to-drink) market is $1.2 trillion in size with traditional tobacco being $800 billion, while the currently “illicit” cannabis market is estimated at $150 – $200 billion in size.

Azer started coverage at Cowen & Co. in September of 2016 and the two questions she asked before starting to examine the sector were: 1) Can Cowen make investors’ money covering cannabis; and, 2) Can Cowen make companies money (presumably bringing private companies public) covering the sector?

The Disruptees:

Within the Consumer Products Group (CPG), there are 4 distinct verticals:

  • Adult Use which includes breweries like BUD, Heineken and Molson (TAP)
  • Beauty & Nutraceuticals which encompasses Coca-Cola (KO), Pepsi (PEP) and cosmetic companies like Estee Lauder (EL)
  • OTC Pain / Sleep, which is primarily Johnson & Johnson (JNJ) and Procter & Gamble (PG)
  • Traditional pharmaceuticals like Merck (MRK), Eli Lilly (LLY), and AstraZeneca (AZN)

Azer noted that both Constellation Brands and BUD had either made investments in the cannabis space already or were interested since the traditional breweries and alcoholic brands were likely to be disrupted from cannabis as consumers see it as a psychoactive substitute.

Don’t forget Canada (The Great White North, eh?)

Azer and Cowen believe that cannabis represents a $12 billion market opportunity in Canada by 2025 with retail accounting for the bulk of the sales. One slide showed the monthly progression of Canadian retail sales in cannabis from October 2018 to March 2019 which cumulatively represented $300 mm (CAD) in retail sales. Cowen seems to see Canada as an early leading indicator of U.S. retail sales since Canada seems so far ahead of the U.S. in terms of its retail rollout. The early retail sales adopters in terms of Canadian provinces are Alberta, Ontario, Quebec and Nova Scotia with each having 24%, 23%, 13% and 8% respectively of Canadian cannabis sales. Alberta has 13% of Canada’s population but 24% of Canada’s total cannabis sales given early bricks-and-mortar adoption.

United States:  

At the time of the lunch, 11 states and District of Columbus had legalized cannabis for adult use. Colorado was the earliest adopter in terms of retail sales but their sales slowed when California and Nevada legalized adult use of cannabis. Cowen estimates that 80% of the $50 billion cannabis market in the U.S. is currently “illicit”.  By Q1 ’19, five states had generated roughly $5 billion in cannabis revenue and those were Colorado, Washington, Oregon, Nevada and California. Cannabis use has clearly come at the expense of alcohol.

Here are the numbers Cowen published as market sizes for various aspects of the cannabis market:

  • THC is an $80 billion opportunity by 2030
  • CBD is a $16 billion revenue opportunity in the U.S. by 2025

Vivien Azer of Cowen did a great job outlining market opportunities and the “macro” of the cannabis/THC/ Hemp/CBD markets. Canada is an interesting comparison since it appears to be out in front of the retail rollout experience. During Q&A, Azer touched on the SAFE Banking Act which will insure access to financial services for cannabis-related businesses. Since the lunch, the House has passed the SAFE Banking Act, but it still hasn’t been passed in the Senate, although passage is ultimately expected.

If you were unable to attend this event but want to learn more about the cannabis industry and where it’s headed, be sure to join us at our next cannabis event hosted by our Education Advisory Group at the beginning of 2020. Information available on the CFA Society Chicago website soon!

Distinguished Speaker Series: David Booth, Dimensional Fund Advisors

In September of 1969, an MBA student took a course that would result in positively affecting the lives of countless people, a couple of universities, and how much of the investment industry would learn to view the world.

It started with two individuals, the University of Chicago professor Eugene Fama and student David Booth. The seed of one idea blossomed into a fifty-year friendship, a history of applying academic research to practical investing and formation of a multi-national investment firm of over 1,400 employees managing $586 billion.

Along the way, after David (student) had learned finance from Gene (professor), the circle was completed as Professor Fama likes to say he learned business from Booth.

It is the only time the professor had been asked to join a student’s business. It was a natural in this case, as the firm, Dimensional Fund Advisors (“DFA” or “Dimensional”) shared the same beliefs having been spawned by ideas Booth picked up in Professor Fama’s course.

Along the way, it should be mentioned that the intersecting worlds of academics, athletics and the arts have also benefited. The University of Chicago named its Booth School of Business in the MBA student’s honor. The University of Kansas named its David Booth Kansas Memorial Stadium in honor of its former undergraduate student (note, Booth has also funded the Booth Family Hall of Athletics in Allen Fieldhouse at KU while donating James Naismith’s original 13 rules of basketball). The Museum of Modern Art has benefited in naming the David Booth Conservation Center and Department in the same man’s honor. Another benefactor has been Georgetown University which named its Booth Family Center for Special Collections within its Lauinger Library. 

It is this story that was told through the voice of the student in the forum of the August Distinguished Speaker Series luncheon on August 14th at the Standard Club. David Booth himself provided the history of Dimensional’s roots, how its one philosophy initiated 50 years earlier, how the firm takes academic ideas and implements them into real world solutions for clients, as well as DFA’s 38-year track record of delivering outperformance versus their benchmarks.

The discussion began with a short video touting the highlights from Mr. Booth’s career which is synonymous with the formation of Dimensional. His friendship with Professor Fama is central to the story. The impact DFA had on the investing universe is also notable, with accomplishments including being pioneers in treating small cap stocks as an asset class and finding a niche between active and passive investing. Dimensional has been styled as “the original factor investors”.

The bulk of the program consisted of an interview/fireside chat with current chair of the CFA Society Chicago’s Board of Directors, Tom Digenan, CFA.

Once again, a chronicle of Mr. Booth’s 50 years in the industry was recounted: how he has inspired people, his mentors (again – Fama was both mentor and a mentee), use of academics, the very large weight put on implementation, and the tension between models and reality in conducting research. 

The importance of TRUST could not be emphasized enough. Especially as it pertained to client relations and the ability to successfully navigate the ups and downs of markets.

Questions were asked about Booth’s thoughts about the significant reduction in the number of publicly traded stocks, his bias toward either active or passive, how DFA utilizes fundamental research, how his firm’s definition of value may have changed over time, and about any change in their thinking now that a new phenomenon of negative interest rates has emerged. His answers to all questions revolved around a single core philosophy that markets are efficient and over long haul there are some simple things an investor can do that will provide a very good experience long term without trying to outguess the market.

Distinguished Speaker Series: Michael O’Grady, Northern Trust

On June 13th local investment professionals gathered at the Chicago Club to hear a “fireside chat” with Michael O’Grady, chairman and CEO of Northern Trust. Marie Winters CFA, past chair of the CFA Society Chicago served as host and interviewer. To begin, O’Grady outlined Northern Trust’s core values that he said were the prime reasons the firm is about to celebrate 130 years of success, and why it remains independent at a time of rapid consolidation in financial services. These values are: service, expertise, and integrity. Northern Trust has focused on these since its inception, with the interpretation, or application, of them evolving to fit the times.  O’Grady expanded as follows:

  • Service applies not just to clients, but also to employees (or partners as Northern refers to them internally), and the community. A commitment of service to these constituents has always driven Northern‘s strategy. While the firm is known publicly for its key products (such as wealth management and asset servicing) it sees itself as a service organization.
  • Expertise is a point of pride for Northern Trust. It employs over 300 charterholders (the most of any firm based in Chicago) but the expertise the firm embraces extends beyond investment management to include other functional areas such as technology, and banking.
  • Integrity, put simply, means always doing the right thing, no matter how difficult. Again, the firm applies this broadly to relationships with partners and the community as well as clients.

Winters’s first question had to do with strategic changes that O’Grady had made since becoming CEO at the end of 2018 (or that he had planned for the near future). He did not answer specifically, but instead listed three drivers of success that he intends to emphasize: 

  1. Service excellence, a combination of his first two core values, which requires understanding the constant change in the business.
  2. Productivity, an absolutely critical need in a time of low revenue growth. Productivity improvements have been a focus at Northern for several years in a program called “Value for Spend”, which seeks to get more out of each dollar of expense.
  3. Investing for growth–determining where the firm should invest now to generate growth in the future.  Again, this reflects the recent history of slower revenue growth. 

Responding to a question about how Northern Trust is addressing the secular shift from active to passive management, O’Grady noted that Northern provides products that follow both strategies. The focus on efficiency is his key to success within passive products because of the low fee levels. Within active strategies, the focus is on leveraging Northern Trust’s expertise in factor-based analysis. Both of these product lines appear in their lineup of multi-asset class solutions.

When asked about investing for ESG (Environmental, Social, and Governance) factors, O’Grady said Northern Trust sees a clear and growing interest from clients. Designing and building such products requires a vast amount of new information and we are only in the early days of reporting that. Gathering accurate information consistently, and analyzing it thoroughly, will be key to success in ESG investing. This is made challenging by the changing nature of our economy.  The number of publicly-traded companies is shrinking, in favor of private companies. Obviously, public companies are more likely to report relevant data pertaining to ESG factors (and in a more consistent manner) than are private companies. So, even for the private equity investor, following ESG strategies is a challenge.

When asked about the importance of technology and digital innovation, O’Grady turned to data security. At front of mind for him was protecting clients’ private information. Technological innovation changes our world faster and faster (blockchain and cloud computing were two drivers of change he mentioned). With this change, clients demand more information, delivered more quickly, but the more we rely on technology to satisfy that demand, the greater the exposure to cybersecurity threats. Ironically, technology will have to be the principal tool in protecting against this risk. O’Grady then made an observation about technological innovation that illustrated one big way it has changed our world. He turned around the saying that “necessity is the mother of invention” to innovation being the mother of necessity. So, not only does technology allow us to do more with less, it also allows us to do things we never thought possible, never knew we could do, and even never knew we needed to do. This gets to the heart of the fears that technology destroys job opportunities. Rather, it creates more than it destroys.

The final area that Winters asked about was how Northern Trust is addressing diversity and inclusion. O’Grady said he’s proud of what Northern Trust has done so far, while acknowledging that the process continues. He specifically noted success in improving diversity metrics in hiring, especially for entry-level jobs, but sees more improvement needed further along the career path. That improvement requires new information that will inform the company on the causes of this shortcoming, and define the corrective actions. So far, they have learned that male managers tend to change roles more often early in their careers, giving the appearance of broader experience when they are considered for promotions. By measuring this and reporting it to managers Northern Trust can hold them accountable for removing any gender-based biases. Further, he noted the firm needs to be more active in assuring that development programs are open to women and people of color and the firm’s culture, which has served it so well for so long, may also have served as an obstacle to advancement. It must evolve to embrace a new commitment to improving diversity.

Diversity improvement was the subject of the first question from the audience about the differences in the various countries where Northern Trust has a significant number of employees. O’Grady acknowledged that policies and actions need to be tailored to the customs, regulations, and existing circumstances in each country. Gender equity is easier to address with consistent policies and programs around the world. However, ethnic diversity requires more customized solutions.

When asked how Northern Trust “walked the talk” on integrity. O’Grady listed three steps: 1) he repeated his rule of always doing the right thing; 2) being transparent, both internally and externally, so your stakeholders understand what you’re saying and doing, and can judge you correctly; and 3) leading by example because telling people how to behave is ineffective. They need to embrace the rules or customs.

When asked what companies O’Grady considers to be his most formidable competitors, he mentioned a few well-known financial services providers but his general comment was more insightful: they need to be mindful of the firms that are excelling at the things Northern Trust also needs to do well. The final audience question asked about Northern Trust’s strategy for growth. O’Grady summarized the firm’s revenue stream as about two-thirds from fees directly connected to the value of the assets they manage or service. They have no control over the value of those assets. The other one-third of revenue comes from earnings on the balance sheet, which are highly correlated to interest rates. Again, they have no control over the level or direction of change in interest rates.  So, they focus on the growth of new business because it’s the factor affecting profit growth that they have the most control over. Secondary factors include productivity improvements (that they see as an offset to inflation), and prudent investments in new businesses or technology.

Distinguished Speaker Series: Charles K. Bobrinskoy, Ariel Investments

Some investors have great analytical skills in assessing current and potential future investments, but the best investors also possess an uncanny ability to both recognize and combat their own behavioral tendencies when making investment decisions. This was the topic of Charles “Charlie” Bobrinskoy’s presentation to a packed room of eager members of CFA Society Chicago and local investment professionals at the Society’s Distinguished Speaker Series luncheon held on May 15, 2019. The program titled, “Combating Unhealthy Behavioral Tendencies in an Investment Firm” discussed how Bobrinskoy’s firm Ariel Investments has adjusted its investment process to incorporate the latest academic findings in the field of Behavioral Economics, and how these process improvements have helped Ariel’s flagship Mutual Fund, The Ariel Fund, become number #1 in its mid-cap value category over the last 10 years.

As way of background, Charles Bobrinskoy is the vice chairman and head of Investment Group for Ariel Investments. Headquartered in Chicago, the firm offers six mutual funds for individual investors and defined contribution plans as well as separately managed accounts for institutions and high net worth individuals. He manages their focused value strategy—an all-cap, concentrated portfolio of U.S. stocks. Bobrinskoy also spearheads Ariel’s thought leadership efforts and takes an active role in representing Ariel’s investment strategies with prospective investors, clients and major media. Additionally, he is a member of the Ariel Investments board of directors. Bobrinskoy is frequently quoted in various news publications such as The Wall Street Journal, Barron’s, Money and USA Today, is a regular contributor to CNBC, and is frequently a guest on Bloomberg Radio.

Many in the room with a CFA curriculum under their belts were familiar with the inherent behavioral biases in our decision making, but Brobinskoy started off by suggesting that he not only was going to share with us the most influential biases, but more importantly, he was going to teach us how to combat them.  Some economists believe that no matter how much we recognize behavioral biases, we are helpless in trying to combat them.  Bobrinskoy and Ariel Investments don’t believe this, and they have purposefully instituted structural processes to combat each bias.

Before jumping into each bias, there are four common observations in the markets that defy efficient markets. The existence of behavioral finance is why each of these market anomalies exist.

  • Stocks beat bonds over the long term.
  • Until the last 10 years, value has consistently outperformed growth.
  • Small caps outperform large caps.
  • And finally, there is momentum in every asset class.

Here is what we learned by bias, in no particular order.

  • Confirmation bias. The tendency to seek data that is compatible with beliefs currently held and to reject conflicting data. Unfortunately, the smarter you are, the more susceptible you are to confirmation bias. A common example is people watch Fox News if they are a Republican and MSNBC if they are a Democrat.

Ways to combat: Appoint a fellow research analyst to play Devil’s Advocate. Challenging another analyst’s assumptions is inherently difficult because it creates conflict. Official appointment of a devil’s advocate actually removes the conflict inherent in challenging someone else’s assumptions because it is his/her job to contradict initial assumptions.

  • Overconfidence bias. The tendency to overestimate what one knows and underestimate the uncertainties of the future.

Ways to combat: Place probabilities on outcomes, and ask for feedback on those probabilities. Ask questions to narrow down the range on probabilities.

  • Anchoring on prior estimates. The tendency to adjust prior estimates insufficiently when presented with new information.   This is why momentum exists in the markets. 

Ways to combat: You need a culture that does not penalize analysts for revisions. Encourage analysts to change their views based on new information that is learned in the market.

  • Loss Aversion. The tendency to overweight losses relative to gains.  This is why there an equity premium.  Investors are willing to accept a certain $5 gain, versus an expected return of $10.

Ways to combat: Ignore your costs basis. Examine each investment decision as if you didn’t own the stock.  Ask yourself, “Would you buy it again today?”

  • Endowment Effect. The tendency to overvalue that which one owns versus that which one doesn’t own.  

Ways to combat: Keep a watch list of what you don’t own that is comparable to what you do own. Look at the data as if you didn’t have any portfolio positions in play and ask, “If I had fresh capital, what would I own today?”

  • Reliance on Intuition over Data. The tendency to think one’s gut instinct is superior to data and to overestimate the significance of very small samples. Model based decisions are always better than guy instinct.

Ways to combat: Always trust the data over intuition. Ask yourself if a decision is data based or on gut instinct. 

  • Vividness/Recency effect. The tendency to measure frequency by one’s ability to think of example which in turn produces a tendency to overweight recent examples.

Ways to combat: Be required to have several examples to prove your point.

For further reading, Brobinskoy suggested three books:

  • Thinking in Bets by Annie Duke.
  • Thinking Fast and Slow by Daniel Kahneman
  • Misbehaving: The Making of Behavioral Economics by Richard Thaler

Last but not least, if you’re a Republican, challenge yourself to watch MSNBC.  If you’re a Democrat, challenge yourself to watch Fox News!

Distinguished Speaker Series: Sheila Penrose, Jones Lang LaSalle

On April 9th, CFA Society Chicago’s Distinguished Speaker Series Advisory Group welcomed Sheila Penrose at The Metropolitan. Penrose is Non-Executive Lead Independent Chairman of the Board at Jones Lang LaSalle, a global real estate services company, and also serves on the Board of Directors for McDonald’s. Penrose retired from Northern Trust in 2000. In her 23 years at Northern Trust, she served as President of Corporate and Institutional Services and as a member of the Management Committee, where she was the first woman to serve. Subsequently, she served as an Executive Advisor to The Boston Consulting Group from 2001 to 2007. She has been on the boards of Entrust Datacard Group, eFunds Corporation, and Nalco Chemical Corp. She has also served on the advisory board of the Gender Parity initiative of the World Economic Forum, the board of the Chicago Council on Global Affairs, and as a founding member of the US 30% Club, a group whose initiative is to achieve female representation of at least 30% on corporate boards.

After detailing some of her credentials and experience, Penrose highlighted three topics she wanted to explore:

  1. What issues are boards of directors discussing the most?
  2. How are boards of directors handling the evolution of the business environment?
  3. How do a group of highly ambitious, competitive and capable people, all of whom are used to leading others, form a functioning team that can effectively oversee a company?

She emphasized that in each topic, boards are fiduciaries for both shareholders and stakeholders, and need to understand how to balance the needs of both groups. She also emphasized that individual board members should be listening and learning all the time, while contributing and remaining objective.

Penrose expounded upon the recent transformation of the business environment as it relates to the board of directors.  Recently, boards have become less dominated by the executive. The CEO/Chairman dual role that was so common in previous years is now no longer as accepted as it once was. This was spurred by Sarbanes-Oxley, but also investors and employees who now have more of a voice shareholder activism has increased. Digital disruption has also been a major category for boards to tackle, and relatedly, managing corporate reputation in an age of social media, where all voices have access to the public. Diversity on boards, and not just different kinds of people, but different viewpoints, has also been an important topic. Boards have been seeking to find people who have different types of experience and different types of expertise, as opposed to finding a group of CEOs for the board. Boards need to develop consensus, not groupthink. She brought up the dilemma of cybersecurity. Boards must wrestle with the questions of how much cybersecurity is enough and how quickly the company can react in the event of a breach. Boards must also consider the impact of global events, as almost all large corporations are now global in reach. Lastly, and importantly, she discussed the issue of talent and corporate culture. Boards must grapple with the future of work and the changes in expectations of their employees. Companies assume they will be able to find the skills they need in the labor market, but they are not doing much to develop those skills in employees and not moving quickly enough to develop people whose jobs might be redundant in the future.

Boards also have to understand how best to find directors. With the changing business environment, new skills are often necessary, and boards have begun looking for people who have those skills, such as digital experience, to help them stay current.

The composition of the board, its dynamic, and its leadership are all critically important. The board should be “collegial but not clubby”, and board decisions should be made in the room, not in private meetings.  Board members should maintain a healthy balance of both listening and contributing.

Individual board members should have what Penrose called “The Four Cs.”

  • Curiosity
  • Conviction
  • Courage
  • Compassion

During the Q&A portion of the event, Penrose described how she believes someone can become a member of a board of directors. She said the individual must have a good reason for why they want to join a board, should be strongly curious and constantly learning, should have experience trying to manage a business on some level, and should be wary of joining a board too quickly. Joining a board too quickly usually means that board is likely of lower quality, and the first board you join dictates one’s future opportunities.

Distinguished Speaker Series: Howard Marks, CFA, Oaktree Capital

Howard Marks, CFA, is co-chairman of Oaktree Capital, where he contributes his experience to big-picture decisions relating to investments and corporate direction. He shared his insights on investing and managing the business cycle for the CFA Society Chicago community on February 22, 2019. His presentation, entitled “Investing in a Low-Return World,” touched on some of the big questions investors are asking themselves today: Should we lower our return expectations? And if so, how do we make money in a low-return world?

Marks describes today’s environment as a “low-return, high-risk world.” Prospective returns and safety are hard to come by in the current over-optimistic climate where people have great trust in the future. Combined with higher risk-aversion, such sentiments lead to asset price appreciation, which means lower future returns, without any lower risk.

Let us follow Marks back to basics to consider what lower returns actually mean. Consider the CAPM model, which shows the trade-off between risk and return. As central banks have lowered interest rate, this line has shifted down. For the same level of risk, you now have lower returns, whether you are investing in T-bills or equity. The CAPM model hints at two reasons why taking more risk is no surefire way to higher returns. For one, the downward shift in the CAPM-line means that returns are lower even for such risky ventures like private equity. Secondly, and more fundamentally, the CAPM does not ensure higher return for riskier assets. As Marks explains, if higher returns were guaranteed for these assets, they would not be risky. For risky assets, therefore, while required returns appear to be higher, there is a wide range of possible outcomes that offer no safe way to high returns.

In Marks’ view, the seven worst words are ”too much money chasing too few deals.” This is what we are seeing today, with returns lower across the board. As Marks clarifies in a memo, “too much money” does not mean investors have more money on their hands to invest, but that they are moving resources out of cash, where returns are low, to seek more risky opportunities, and as such, push down required returns on riskier investments.

What, then, is an asset manager to do in this environment? You cannot both position yourself correctly in a heated bull market and be positioned for reversal at the same time. Counting on historical returns being the same in the future is foolish but settling for today’s low returns contradicts the business plan of most organizations. You may not survive in the business if you go all into cash and wait for a better environment.

As an asset manager, argues Marks, you have two jobs, that of asset selection and cycle positioning. You cannot give up on timing when to be aggressive because then you cannot ever be defensive. Cycle positioning does not mean forecasting economic growth for the next year. Marks makes very clear that he does not believe in forecasting. Instead, you need to understand where you are in the relevant cycles, such as the business cycle, credit cycle, and the market psychology cycle. Knowing where you are gets the odds on your side. It does not mean you can predict what will happen tomorrow but it should tell you whether to be more aggressive or more cautious. Marks explains that there are times for aggressiveness and times for caution:

  • When prices are low, pessimism is widespread and investors flee from risk, it is time to be aggressive.
  • When valuations are high, enthusiasm is rampant and investors are risk-tolerant, it is time for caution.

It seems Oaktree’s view is that the current environment is a mixed bag. For the past three years, their mantra has been “move forward but with caution.” This, as Marks explains, means being fully invested while biasing the portfolio towards defense rather than offence.

In addition to getting the cycles on your side, explains Marks, there are opportunities for alpha also in the current environment. Despite low returns overall, there are mispricings to exploit. You do have more and less efficient markets, and with the right set of skills, you can identify them. This is harder than it used to be, when there were more structural and persistent inefficiencies to exploit. Nowadays, most inefficiencies are cyclical, and emerge only once in a while.

In inefficient markets, some investors will earn positive alpha, and some negative alpha, so you should enter these markets only if you think you can be on the right side of the trades. You can do this only if you dare to be a contrarian. Going this rout is risky and costly but it is the right way to invest if you have the skills to do it.

For additional reading, see Howard Mark’s memo “Risk and Return Today.” You can find all his memos while at Oaktree here. You can also view the CFA Society Chicago luncheon presentation below.

Distinguished Speaker Series: Joel Greenblatt, Gotham Asset Management

Joel Greenblatt, the legendary author, Columbia B-school professor and hedge fund manager, presented his thoughts and methodology on investing to CFA Society Chicago and local investment community on Wednesday, December 5, 2018.

The title of his presentation compared value investing to the New York Jets, i.e. unpopular and out of favor. Per Greenblatt, where we stand today on a valuation basis relative to the past 25 years is that about 25% of the S&P 500 could be considered “undervalued” versus just 7% of the Russell 2000, if we assume the S&P 500 earns its long-run average forward return of 7%. Greenblatt also thought that the S&P 500 could earn a below-average 3%-5% return for the next few years.

In a statement that was likely no surprise to anyone in attendance, Greenblatt noted that “Growth” has outperformed the market the last 5 years. Greenblatt defined for attendees what the parameters were for a value investor (with all of these definitions supported by the Russell and Morningstar definitions:

  • Low price-to-book
  • Low price-to-sales
  • Low cash-flow valuation

What Greenblatt admonishes his students to aspire to, “Do good valuation work, and the market will likely agree with it”. Greenblatt noted he just wasn’t sure when the market would agree, but in theory at some point it will.

Greenblatt put up the chart that showed the classical individual stock return versus company valuation, and to no surprise to anyone, the overvalued stocks typically had the lowest forward returns relative to the lowest valuation. He also used the examples of two lectures he gave to a group of NY doctors who only asked what he thought the market would do over the next few years, versus the Harlem high school jelly bean test, and asking the kids to guess as to the number of jelly beans in the jar. Joel Greenblatt used the story to lead listeners to the conclusion that the kids in Harlem were closer to the right answer in terms of the accurate number of jelly beans in the jar, when doing their own homework versus listening to “word-of-mouth” guesses by the class.

It was clear that Greenblatt was more impressed by the analytical rigor of the Harlem high school class than the group of doctors, but he also used the story to illustrate the power of impression and what is heard by the retail investor and how emotion and psychology play important roles in investing. Greenblatt also talked about one of first books, i.e. The Big Secret for the Small Investor and the two most important points from the book:

  • 41% of the investment managers with the best 10-year track records also spent at least 3 of those years in the bottom decile of performance rankings.
  • The “Big Secret” is really just patience. Find an investment strategy that you are comfortable with and stay with it.

Greenblatt noted that the press’s preoccupation with Tesla is the “tyranny of the anecdote” contrasting that with deep value investing strategies and how they work over long periods of time.

The Q&A session noted that – not surprisingly – Greenblatt finds more opportunities in the smaller-cap universe despite the valuation comments from above. The valuation metrics aren’t “weighted” in that price-to-sales isn’t weighted more heavily than price-to-book although from his side comments and what were more impromptu thoughts by Joel, price-to-cash-flow and cash-flow health was rather significant.

Greenblatt did note that with “international” investing, the Professor’s fund trades long-only since with international there are trading costs, different forms of regulation, liquidity and other notable differences between US and Non-US investing.

 

*If you missed the event the webcast of the full presentation is still available to watch on the CFA Society Chicago website.

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

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

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

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

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

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

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

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

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

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

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

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