Distinguished Speaker Series: Jimmy Levin, Och-Ziff Capital Management

dsc_3148With interest rates at historic low levels and equity markets at concerning valuations, the subtitle of Distinguished Speaker Jimmy Levin’s presentation on October 4th, Finding Value in the Current Investment Environment, was alluring to say the least. Levin is Executive Managing Director and Head of Global Credit at Och-Ziff Capital Management, a manager of alternative asset strategies for institutional investors. The firm focuses on equity, real estate, credit, and—in particular–multi-asset strategies.  As of the presentation date Och-Ziff was managing approximately $36 billion in assets with nearly half that falling within the firm’s broad definition of the Credit sector. They separate Credit into two categories: Institutional (primarily Collateralized Loan Obligations—CLOs) and Opportunistic. They further separate Opportunistic Credit into Corporate (meaning any single-payer form of debt including sovereign and municipal debt) and Structured Credit which includes all manner of securitized, or asset-backed pools.  Distressed situations are common to both products, and often involve litigation and liquidations. A defining feature of the situations Och-Ziff finds attractive is the opportunity for the firm to exert influence over the resolution of these distressed situations. They prefer to exert this influence in a cooperative manner, but circumstances may require them to play an adversarial role.

Levin asserted that finding value in the current environment requires searching in pockets of the market that are less efficient because institutions, mainly investment banks, are less involved than was the case prior to the financial crisis of 2008-09. Situations involving corporate restructurings were once very big for Och-Ziff but this niche has become very competitive in recent years with more players crowding into the space. Instead Och-Ziff has found success by concentrating their efforts in three areas:

Structured Finance, or working out broken-down, asset-backed products: The securitized market is many times larger than the U.S. High Yield market and the products are more complicated, making for a much less efficient market. The structures were designed to be “bankruptcy- remote” and, therefore, the governing documents do not provide any rules or guidelines for restructuring. That allows a manager able to do its homework and understand the situation to exert a great deal of influence on the resolution.

Market Cycle Trades (essentially market timing): It’s impossible to call turning points perfectly, but a careful manager can make informed judgements on when a market is especially cheap or rich and adjust risk exposures accordingly.  Success here requires that the manager take a contrarian approach, maintain enough liquidity to support opportunistic trading, and be ready to take the opposite side of trades when others are either overly fearful or greedy. Equally important is maintaining moderate risk when the market is not at an extreme valuation.

Bank Disintermediation Trades: Opportunities presented by changes in the regulatory environment since 2009 have reduced the number of market makers as well as their level of activity.  During a period when the size of the credit markets has approximately doubled, sell side activity by any metric has declined by perhaps as much as 80%. The obvious result has been sharply diminished liquidity in all sectors of the market, especially during times of stress such as the first quarter of 2016. These present attractive risk/reward opportunities for managers who are ready, willing, and able to step in and provide liquidity when others can’t. Success here requires patience and flexibility, characteristics that are now lacking in banks because of tighter capital requirements.

The keys to success in all three of these strategies include smart, incisive analysis; astute trading; thorough understanding of complicated structures; and the discipline to be selective about when to enter or exit positions.

Distinguished Speaker Series: Jeffrey W. Ubben, ValueAct Capital

Come so far…now the slog

dsc_3125CFA Society Chicago’s Distinguished Speaker Series hosted Jeffrey W. Ubben at the University Club. Mr. Ubben is Founder, Chief Executive Officer and Chief Investment Officer at ValueAct Capital. Prior to founding ValueAct, Mr. Ubben was a portfolio manager at Fidelity and a managing partner at Blum Capital. ValueAct is a hedge fund that invests in companies in fundamentally “good” businesses that are available at depressed valuations. The company typically manages 10-18 investments with total assets over $11 billion.

Although Mr. Ubben’ s hedge fund is located in San Francisco, he spent part of his life in the Chicago area and is a graduate of the Kellogg School MBA program at Northwestern University. His appearance at the University Club was in part a homecoming; his parents were in attendance.

Mr. Ubben began his presentation with three charts that chronicled the history of the debt and equity markets beginning in the late 1970’s to its current state. They were as follows:

  • “Corporate Equities to GDP”
  • “Governance Timeline”
  • “US Total Credit Market Debt as % of GDP”

The corporate equities and credit market charts illustrated the rapid growth of the equity and debt markets in comparison to GDP. Mr. Ubben blames “fed-induced financial engineering” for the outsize growth of debt.  Historically low interest rates have fanned these flames as companies have gotten a free pass to increase leverage. He lamented the thinking that stocks are the new bonds and feels that stocks are currently priced nearly to perfection. The “Governance Timeline” showed a history of shareholder activism beginning with hostile LBO’s in the late 1970’s to current attempts by shareholders to change the composition of target companies Board of Directors.

Mr. Ubben stated that value investors like him are attracted to what he termed “pain” experienced by many corporations. This “pain” eventually incents corporations to make decisions that will benefit shareholders. His examples of “no pain” were corporate deal making and lavish pay to CEO’s like Google’s Eric Schmidt.

Mr. Ubben briefly discussed three investments recently made by ValueAct in companies currently experiencing “pain”. These were positions in Rolls Royce, Morgan Stanley and Baker Hughes. In each case Mr. Ubben state briefly what attracted ValueAct and what changes were being made to secure a brighter future for each company. Perhaps this was the “slog” he alluded to in the title of his presentation.

The role ValueAct had in the removal of Steve Ballmer from Microsoft was also discussed. Mr. Ubben stated that he merely encouraged management to listen to its major shareholders opinion of Ballmer’s performance. In contrast, Mr. Ubben made mention of Jeffrey Immelt’s action in selling GE Capital’s multibillion dollar portfolio of real estate assets. GE’s share price has since improved markedly.

There was a lively question and answer session following the presentation. Mr. Ubben was questioned further about ValueAct’s investments. These included questions concerning Morgan Stanley, Valeant Pharmaceutical, Trinity Industries and Alliance Data.

ValueAct’s investment in Valeant Pharmaceuticals was one of which Mr. Ubben spoke at some length. He was quick to admit that this was an investment where ValueAct had taken its eye off the ball. They were instrumental in the CEO change that occurred in 2008 which brought in Michael Pearson. However, Pearson became very aggressive and this led to bad decision making.

Mr. Ubben reiterated his advice to go where there is dis-investment as this is a place where there are lower costs and lower volatility. It is important to measure the quality of any business versus its valuation. Despite many stocks and industries being priced to perfection, there are still parts of the market where opportunities can be found.




Distinguished Speaker Series: Dr. David Kelly, CFA, J.P. Morgan Global Investment Management


Dr. David, Kelly, CFA

Dr. David Kelly, CFA, the Chief Global strategist for J.P. Morgan Global Investment Management, provided his thoughts and views on investing in the current low/no rate environment.

Starting with a review of the U.S. economy Kelly noted that real GDP has grown just over 2% on average over the past five years. Under normal circumstances this level of growth is considered anemic, but the current slow and steady expansion is acceptable from Kelly’s point of view. Consumers are benefiting from low mortgages and gas prices, overall demand is growing, and banks are issuing more credit. Kelly considers this economy analogous to a healthy tortoise – it does not move swiftly, but it is steady. It is unrealistic for the U.S. economy to grow at historical levels (+3%) given the low unemployment rate, which from Kelly’s point of view is the biggest impediment to continued growth of the economy. Kelly believes that the sliding unemployment and labor participation rates are due to the aging population. Baby boomers comprise a large segment of the working population, the oldest of which became eligible for retirement in 2011. Boomers will of course will continue to retire, constraining the labor market, and helping the unemployment and participation rates to fall further. To combat the coming labor shortage Kelly suggested comprehensive immigration reform, bringing more people (workers) in to the U.S.  If immigration reform is not successful the unemployment rate could fall into the 3% range, constricting the economy to a growth rate under 2%.

Kelly believes that the Federal Reserve needs to raise rates in September. If this window were missed then the Fed would likely have to wait until December to not affect the November election. Further delays in raising the Fed Funds rate will make raising rates harder to do in the future – the Fed will be provided with more reasons for not raising rates, which will further undermine its credibility.

dsc_3084As of April 2016, 35% of all developed world government bonds had a yield below zero. Low global rates have helped lower U.S. interest rates. Global bond buyers looking for better yields have moved to U.S. denominated securities driving down domestic yields. However, Kelly suggested that rising rates in the U.S. could act a balloon to world bond rates. Given the current and projected fixed income market, Kelly suggested underweighting domestic and global fixed income until real rates reach a normalized range.

Turning to the equity markets Kelly believes the current equity market is still relatively cheap. Do to the expected rising rate environment the financial sector should be overweighed while the utility sector is expected to underperform. However, there is more upside outside of the U.S. equity market in Europe and the emerging market space.  These areas should outperform in the medium term based on stronger relative earnings. The current forward P/E of the S&P 500 is around 17x earnings, over the long-term average of 16x, while the MSCI EAFE forward P/E is at its long-term average.

Kelly took questions at the end of the presentation from several members from the audience. One individual asked “How best should a government sustain a countries economic growth?” Kelly’s answer was a bit surprising in that he focused on income inequality – the more there is, the less sustainable economic growth becomes. Kelly noted that most problems that create income inequality start with single parent families (SPF). In the 1980’s, 18% of households were SPF. As of this past year the SPF households number 42%, which from any number of perspectives is an alarming statistic.

Distinguished Speaker Series: Charlie Dreifus, CFA, The Royce Funds

DSC_2907“The proliferation of non-Gaap (financial measures) has added to the proliferation of growth,” said Charlie Dreifus, CFA.

Dreifus is a managing director and portfolio manager with The Royce Funds which focuses on providing small-cap, value mutual funds.  Dreifus is the portfolio manager for the Royce Special Equity Fund and the Royce Special Equity Multi-Cap Fund, with over 18 and 5 years on the funds, respectively.

Dreifus’ focus, for many years, has been on the value approach to portfolio management.   A key aspect of his approach is the utilization of accounting skepticism.  Dreifus shared his thoughts on the increased usage of non-GAAP measures and the resulting side effects.

He started with a story.  He had a conversation with a particular company to seek GAAP guidance.  Although the company already provided non-GAAP guidance, Dreifus was informed that “GAAP guidance is unavailable without unreasonable effort.”  Dreifus responded, “…but you need GAAP to get non-GAAP.”  And the attendees broke out laughing.

DSC_2918Dreifus reported that the number of S&P companies reporting non-GAAP measures has increased to 88%.  The consequences of the increased focus on non-GAAP include decreased clarity in reporting results and in increase in wiggle room to achieve desired results.  The desired results have, of course, have a direct linkage to executive and incentive compensation.  Executive compensation is being geared more towards non-GAAP and with the ability to front load expenses with non-GAAP measures, financial windfalls can be significant.  Audit committees have been strengthened by Sarbanes-Oxley.  Dreifus would like to see the committees act to disallow the gaming of earnings to beat analysts’ expectations.  They should take more responsibility for the reported economic stats.  Ideally, we would see “full, fair & balanced reportable numbers.”

Dreifus finds the number of times audit committees meet informative.  If the number is low or high, it raises a red flag.  He would like to believe that changes to our non-GAAP reliant system would develop within the audit committee; however, the challenge is sparking any involved person/party to take ownership of the responsibility.

On the other hand, Dreifus does grant that GAAP is not perfect either.  Nevertheless, his goal is to raise the level of consciousness within the industry and its participants.  Especially in the context of recent record-setting equity market levels, the talk has motivated deeper reflections on valuations.

Distinguished Speaker Series: Liz Ann Sonders, Charles Schwab & Co, Inc


The Distinguished Speaker Series recently welcomed Liz Ann Sonders at the Metropolitan Club in the Willis Tower.  Ms. Sonders is currently Chair of the Investment Committee at Windhaven Management Inc., and is Senior Vice President and Chief Investment Strategist of Charles Schwab & Co, Inc.  Her responsibilities at Schwab include market analysis and interpreting economic trends for Schwab clients as they pertain to the equity market.

It is Ms. Sonders view that the following factors mostly favor this “unique” bull market:

  • Central bank policies have diverged with Japan and ECB leading the way in providing any perceived need for liquidity. The US central bank is not going down this path, but rather is looking for opportunities to tighten liquidity.
  • Due to the continued outperformance of the US economy, global economic indicators remain slightly positive. The level of pessimism remains high.
  • A generational shift toward higher savings as driven by the “great recession of 2007-2008” has muted the recovery.
  • The 5-year normalized P/E ratio reveals that the equity market’s value is only slightly above average. This metric is her preferred method of determining the richness of the equity market.
  • Corporate earnings hit a trough in the first quarter, but will recover for the remainder of the year.
  • Leading economic indicators do not lead to the conclusion that a recession looms in the near future.

Ms. Sonders claims the twitter hashtag #NoRecession as her idea; however it is far from “trending” and she does not expect that it will.  The level of pessimism concerning the future of the equity market can be compared to sentiment following the crash of 1987.  This is reflected in equity fund flows that remain negative for equities, making the market mostly reliant on corporate buybacks.

Inflation is something that might derail the bull, and per Ms. Sonders it should be on investors’ radar.  Commodity and wage pressure have not forced the Fed’s hand, however they are keen on attempting to normalize rates.  The velocity of money is most important and that has been slow to increase.  Ms. Sonders postulates that the Fed is driven more by the currency markets and the strength of the dollar may be more of an influence of the direction of the Fed.

Ms. Sonders also touched on the high amount of government debt now held by the US and how she thinks that is affecting the economy.  She stressed that high debt levels have led to low US growth and made the economy prone to mid-cycle slowdowns.  However, it has also served to dampen economic cycles on both the upside and the downside.

In her opening remarks Ms. Sonders referred to Martin Zweig and Sir John Templeton who helped shape her thoughts as an investor.  Sir John Templeton stated that bull markets mature on optimism and die on euphoria.  It appears that we have yet to reach the “optimism” stage.  Bull markets have never been killed by longevity.

In the Q&A session following the presentation Ms. Sonders commented on the following:

  • Gold is less an inflation hedge and is now being used more as an alternate currency. Some sovereign debt now has negative carry similar to gold.
  • Active strategies now have an advantage over passive investment strategies; there will be no reversion to a “nifty 50” as seen in the 1970’s.
  • Increased wages have implications for inflation; a September rate hike is not unrealistic.

CFA Society Chicago Company Presentation: AstraZeneca

DSC_2846The prospect of curing or even “containing” cancer has proven to be an elusive goal. One company that has recently joined the battle against this disease is AstraZeneca, a UK based Biopharmaceutical Company. On June 6th, CFA Society Chicago hosted a presentation by AstraZeneca given by Luke Miels, Executive Vice President Global Products and Portfolio Strategy. Mr. Miels outlined AstraZeneca’s going forward strategy and its plans to return to growth in 2017.

After a brief review of the company’s most recent acquisitions, Mr. Miels illustrated that an increase in research has yielded an increasing number of high-impact publications and Phase III trials of prospective breakthrough drugs. This increase in research and development has set the table for an acceleration of growth that is forecast to occur in 2017.

AstraZeneca will focus on three main therapy areas: Respiratory, Inflammation & Autoimmunity, Cardiovascular & Metabolic disease, and Oncology. There are currently 10 AstraZeneca drugs in late-stage development targeted to treat these diseases. The drugs he highlighted did not exist five years ago. Mr. Miels went on to describe five growth platforms that will support the three main therapy areas. These platforms currently represent 56% of AstraZeneca’s business.

For each of the three main therapy areas, Mr. Miels listed the existing or late-stage trial treatments, the evolution of the treatments and the areas for which the treatments are most profitable. It appears that AstraZeneca is having its greatest success in emerging markets and the EU. It has developed successful treatments for severe asthma and COPD (Beralizumab), a super-aspirin (Brilintal/Brilique) and a treatment for diabetes (Faxiga).

AstraZeneca is a relative newcomer to Oncology. There are new treatments in development for ovarian cancer (Lynparza) and lung cancer (Tagrisso). AstraZeneca intends to focus on tumor resistance, DNA damage response, Immuno-oncology and antibody conjugates in its fight against this terrible disease. The ovarian cancer and lung cancer treatments appear to be more effective for patients with DNA mutations that make them susceptible to these cancers.  Research is ongoing by multiple drug companies on what treatments might make the immune system be able to recognize and fight an invading cancer.

There were several questions posed to Mr. Miels following his presentation. They focused on patent expiration and generic drugs. One question focused on the manufacture of a drug after patent expiration. Mr. Miels stated that it still was cheaper for the company with the patent to manufacture the now generic drug; however there is little incentive for the company to do so.  Another question concerned the efficacy of a biologic generic drug.  Mr. Miels stated that generics of chemical drugs are exact copies, however due to the nature of its manufacturing; biologic drugs are never exact copies.

Distinguished Speaker Series: Tom Ricketts, CFA


Chairman of the Chicago Cubs and Incapital LLC, Tom Ricketts, CFA, speaks to local financial and investment professionals at the Standard Club on April 12, 2016.

After his family acquired the Cubs in 2009, Tom Ricketts, CFA, found the storied franchise in disarray. Despite not winning a World Series championship in over a hundred years, the team continued to pack fans into historic Wrigley Field. But with the 3rd highest payroll and the 2nd worst record in the National League in 2011, success didn’t seem to be just around the corner. In a presentation to CFA Society Chicago, Ricketts offered his playbook for turning the perennial “Lovable Loser” Cubs into a championship-caliber squad in just five years.


“Every single day I wake up and think about winning the World Series” – Tom Ricketts, CFA

As the team’s new owner, Ricketts put forth three goals for the organization:

  1. Win the World Series
  2. Preserve historic Wrigley Field
  3. Act as a contributor to the community

“Every single day I wake up and think about winning the World Series,” said Ricketts. He shared an interaction he often has with older Cubs aficionados: a fan approaches and tells him “Mr. Ricketts, I’m 70 years old and a huge Cubs fan, can you please win the World Series before I die?” To which, Mr. Ricketts typically responds, “Well, how’s your health? Are you exercising and eating healthy?”


Tom Ricketts, CFA, and Distinguished Speaker Series Advisory Group member, Jim Stirling, CFA, meet with attendees before the presentation.

When Theo Epstein was hired as General Manager, the Cubs had a poorly ranked farm system and a very old, overpaid team. The Tribune organization, which Ricketts reckoned wanted to win as much as any owner, seemed to focus on short term success and viewed each season as a “discrete event”, hardly the way to build a championship team in his opinion. The Cubs executives began their quest for a championship by looking extensively at data. One thing they found was that the correlation between regular season winning percentage and playoff winning percentage is often somewhat low. In fact, many Wild Card teams haveended up winning the World Series in the past decade. Ricketts interpreted this as regular season records not mattering as much as simply reaching the playoffs for a chance to win.

Another insight that came out of their research involved the relationship between payroll and winning. A commonly held view by the media is that if you spend a lot of money on talented players, you will win a lot of games. Sports writers often consider payroll expenditure a good proxy for a franchise’s commitment to winning. After analyzing the data, the Cubs management realized that this simply wasn’t true.


Tom Ricketts, CFA, with CFA Society Chicago’s Executive Committee. (L to R: Doug Jackman, CFA; Marie Winters, CFA, CAIA; Tom Ricketts, CFA; Kerry Jordan, CFA; Shannon, Curley, CFA

“Correlation between payroll size and winning percentage is much lower than you’d expect. You can’t just go out and buy wins,” Ricketts said, proving his point with a graph of the two variables’ low R-squared (a measure of goodness of fit of a model). The correlation between high payroll and winning percentage has subsequently declined even further in the past few years. Ricketts sought to understand why that might be. He found his answer in Major League Baseball’s contract system, which divides a player’s lifecycle into three phases:

  1. MLB debut
  2. Arbitration
  3. Free Agency

During the MLB debut phase, players often earn far less than their fair value. For instance, last year’s NL Rookie of the Year Kris Bryant will earn just $652,000 in 2016, despite batting more home runs than all but 13 players in the National League in 2015. Meanwhile, 35 year-old Curtis Granderson was less productive than Bryant, finishing with 29 fewer RBIs in 2015, yet is paid over 20 times the amount Bryant receives. This shows the asymmetry between production and cost that Ricketts says can hamper teams’ efforts to win.


The Distinguished Speaker Series luncheon featuring Tom Ricketts, CFA, was one of the largest with more than 350 attendees.

The arbitration phase was characterized by Ricketts as a presentation by a player’s agent saying effectively that the represented player “was probably the best player on the team, and should receive an appropriately massive salary”, while the team’s presentation would sound more like “This individual shouldn’t even be in baseball and is fortunate to receive anything at all.” Following both presentations to a neutral arbitration panel, teams and agents will often meet somewhere in the middle on salary.

After six years following the debut and arbitration phase, salaries finally become lucrative as Major League Baseball players enter free agency. The problem for a team is that by the time a player reaches this stage, their Wins Above Replacement value (Wins Above Replacement, or WAR, is an overall measure of a player’s production and value) has typically peaked, and teams end up overpaying heavily for aging, declining talent. This was the case with the Cubs team that the Ricketts family inherited from the Tribune Corporation.

A slide charting the average players pay alongside WAR was shown, depicting a huge mismatch between value and pay early and late in a player’s career. The left portion of the chart (early on in a player’s career when their value to their team exceeds their pay) indicated an economic surplus for the organization, while the right portion of the chart (when a player’s pay exceeds value-added) showed an economic surplus for aging players. Puzzlingly, free agents sign the most lucrative contracts of their careers almost exactly when their production begins to slow down.

Another factor exacerbating the effect of low WAR relative to salary in players’ later years (i.e. free agency) is the growing practice of teams giving young, highly talented players longer contract extensions. Buster Posey’s 8 year, $167 million deal at age 26 was used as a good example of this. The net effect of longer contracts for star players is that quality players are entering free agency at an older age, when their WAR has typically peaked and their talents are in decline. Given these developments, it has become harder and harder to “buy a winner” and simply acquire high-priced free agent talent in order to win the World Series.

In light of that information, what were the Cubs to do in order to build a winner?

Their solution: focus on building a core of young, homegrown talent.

A number of other problems plagued the Cubs in 2011. According to Ricketts, the team had perhaps the worst facilities in Major League Baseball and didn’t have a clear philosophy on how to play the game. The Cubs developed the following plan:

  1. Upgrade all facilities
  2. Improve and expand scouting capabilities
  3. Focus on player development – create a “Cubs way” including a how-to manual for players detailing how to play the game
  4. Talent Acquisition
  5. Contract Extensions

The Cubs made a series of trades focused on length of control and getting younger, often moving older, more established players for prospects. The average age of their traded players was 31, compared to an average age of 23 for players received in trades. Ricketts reviewed several recent Cubs moves. According to the Cubs Chairman, the trade for Jake Arrieta was “the best trade in the history of mankind”, which was met with laughter and smiles by the audience.

After shedding older players and their costly contracts, developing prospects was the next key part of the Cubs strategy for sustained success. Ricketts noted that 24 out of 50 players playing in the 2015 World Series between the Mets and Royals were homegrown talent – players who had come up through each team’s farm system. The Cubs aggressive moves to cut older players and focus on improving their pipeline paid off in a big way. By 2015, ESPN reported that the Cubs had the #1 farm system in the MLB. In just five years after beginning a rebuilding effort in 2011, the Cubs entered the 2016 season with the most talented squad in the Major Leagues.


CFA Society Chicago Vice Chair, Doug Jackman, CFA, welcomes Tom Ricketts, CFA.

On rooftops, Ricketts opined that it’s a difficult business situation when people across the street have access to your product for free. The practice of watching games at Wrigley on Waveland and Sheffield avenue rooftops began organically, with residents bringing up a cooler of beer and occasionally inviting a friend over to watch the game. Then some enterprising individuals began charging fans to go up on their rooftops and take in the Cubs, forever changing the rooftops into a commercial endeavor. The Tribune Corporation viewed rooftops as a threat and moved to block their view of the field. Rooftop owners responded by petitioning the City of Chicago to assign landmark status to three distinct elements: the marquee, the scoreboard, and most critically for them, the “natural slope of the bleachers”. The last item effectively prohibited the Cubs organization from blocking the rooftops’ view. Now, Ricketts said, the Cubs have made peace with the rooftop owners, their presence being one of the most distinct aspects of watching a baseball game at Wrigley Field.

Distinguished Speaker Series: John V. Miller, CFA


A State of Political Brinkmanship: Illinois at the crossroads, again.

How can a state with a large, diverse economic base have a credit risk premium in junk bond territory? It’s easy, when political brinkmanship and years of fiscal mismanagement create an enduring state of legislative paralysis.

That’s right, according to John V. Miller, CFA, Managing Director and Co-Head of Fixed Income at Nuveen Asset Management, Illinois’ economic base should support a AAA credit rating and yet its general obligation (GO) bonds currently trade below investment grade—at a 140 basis point credit risk premium.

Miller, who recently spoke at CFA Chicago’s Distinguished Speakers Series luncheon, cited decades of budgetary imbalances and the state’s failure to properly fund its pension plans as primary reasons why Illinois has the lowest credit rating in the nation (Baa1 from Moody’s, A- from S&P and BBB+ from Fitch).

Yet, all is not lost. If the political gridlock in Springfield can be broken, the path back to fiscal health is not that complicated. It will just take time and discipline

The Illinois Budget Stalemate: A Public Disservice

Illinois has been operating without a budget since July 1, 2015. Disagreements over needed spending reforms, increased taxes or both have created an epic budget stalemate which may drag into fiscal year 2017. Miller says the stalemate is, “more entrenched than anyone can imagine. The parties are far apart and passionate about it.”

In the meantime, the citizenry suffer. State appropriations for higher education and funding for social services have been cut off. This led Moody’s to downgrade the credit ratings of Northern Illinois University, Northeastern Illinois University and Eastern Illinois University on February 24, 2016. The list of affected organizations, and the people they serve, is long and includes:

Sadly, from Miller’s point of view, the legislators appear more concerned about picking up additional seats in the November 8th general election than resolving the budget stalemate. He feels that eventually there will be enough voter angst for someone to lose political support—and that would be a good thing. After all, it’s supposed to be about public service, right?

Long-term Problems Require Long-term Solutions

One of the most important points Miller made was that it took a long time for Illinois to build up the magnitude of deficits we’re dealing with and we should all realize that it will take a long time to fix them.

The 2017 fiscal year budget gap is estimated to be about $6.6 billion, or about 20% of revenues. While that sounds insurmountable, Miller says that if Illinois were to increase the individual income tax rate back to the 5% rate that was in effect from 2011 to 2014, it would raise $4.1 billion and cover most of the projected deficit.

Even with that increase, Miller says Illinois would have the 16th lowest personal tax rate in the nation and he feels it’s highly likely that a tax increase will need to be part of the solution. And, in my opinion, we need spending reform and term limits as well.

Public Pension Plans

Illinois’ public pension plan deficit is another story. At $111 billion in unfunded liabilities, and a combined funded ratio across all plans of only 41.9%, it’s often described as the worst funded pension system in America.  How did this happen? According to David McKinney, of Crain’s Chicago Business, it didn’t happen by accident.

In McKinney’s October 2015 article, The Illinois Pension Disaster: What went wrong?he shows that Governors and legislators, Republicans and Democrats, repeatedly approved financially toxic changes to the plan. In short, here are the big reasons why Illinois’ plan is so underfunded today:

  1. Deferred Pension Payments– Known as “The Edgar Ramp,” state contributions were set artificially low in the 1990s causing contributions to accelerate dramatically in 2012. This is an example of “kicking the can down the road.” The deferred amounts eventually have to be paid but with compound interest.
  2. No Pension Payments– If deferring pension payments is a bad idea so is skipping them. Illinois declared a “pension holiday” in 2005 and 2006, avoiding $1 billion in payments per year, based on false sense of security created by a 2004 borrowing plan that boosted the funding status to 61%. In total, underpayments from 1985 to 2012 were $41.2 billion.
  3. Increased Benefits– In 1989, a compounding 3% cost-of-living adjustment (COLA) was added to the benefit promise and another round of enhancements in the 1990s. Today a “consideration plan” is being discussed which presents a choice between giving up COLA increases and including pay raises in the calculation of the calculation of retirement benefits. Miller points out that the “consideration” model could save up to $1 billion in annual costs and cut the annual contribution by 15%.
  4. Early Retirement Offers – A 2002 early retirement offer (for those over 50 years old) created a stampede of 11,039 retirements that increased the liability by $2.3 billion.
  5. Poor Investment Results– The collapse of the 2000 dot-com bubble and 2008 stock market meltdown then added $15.9 billion in investment losses to the liability. Some perceive these events as largely outside of the state’s control but, in reality, they are related to the plan’s investment policy statement and risk management program. For more on how to effectively manage a defined benefit pension plan see Pension Finance: Putting the Risks and Costs of Defined Benefit Pension Plans Back under Your Control by M. Barton Waring.

In Miller’s opinion, the Illinois Supreme Court’s decision finding Illinois’ 2013 pension reform law unconstitutional was brutal from an economic point of view. He points out that other states have been able to make adjustments to their plans, the COLAs and/or complete conversions to 401Ks.  However, Illinois law has some of the toughest language in the nation on protecting pension benefits. And last week, the Illinois Supreme Court also rejected plans to cut future retirement benefit plans for Chicago city workers.

The fact remains that both Illinois and the City of Chicago significantly underfunded their pension plans, well below actuarial required payments, for years. In my view, the Supreme Court has it right. Illinois has always needed legislative leaders with the fiscal discipline to carry through on the state’s commitments, while avoiding toxic financial mistakes, and the ability to appropriately modify future retirement programs.

The following quote, by Winston Churchill, aptly describes the conundrum.

“When the situation was manageable it was neglected, and now that it is thoroughly out of hand we apply too late the remedies which then might have effected a cure. There is nothing new in the story. It is as old as the sibylline books. It falls into that long, dismal catalogue of the fruitlessness of experience and the confirmed unteachability of mankind. Want of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self-preservation strikes its jarring gong–these are the features which constitute the endless repetition of history.”

—House of Commons, 2 May 1935, after the Stresa Conference, in which Britain, France and Italy agreed—futilely—to maintain the independence of Austria.

Act and the Bond Markets will Respond 

As simple as it sounds, the bond markets will respond favorably to positive fiscal actions. Miller noted that the credit risk premium on Chicago GO bonds dropped by over 100 basis points after the City of Chicago approved a $543 million property tax increase in October of 2015 (slide below). He explained that that getting rid of variable rate debt and swaps while raising taxes sends the right signal to the market.



However, Chicago’s GO spreads are up again due to contagion from the Chicago Public Schools (CPS) deteriorating fiscal condition. The Chicago Teachers Union has approved a one-day teacher walk out on April 1, 2016 which adds more pressure to the situation. Unfortunately, as we saw earlier in this story, it’s often the most vulnerable that get hurt when we reach this level of political brinkmanship. Let’s hope some positive steps can be taken, and the markets will take notice.

Distinguished Speakers Series: John Rogers, Jr.

On February 10th CFA Chicago’s DistinguishedRogers Speaker Series advisory group hosted John Rogers, Jr., Chairman, CEO and Chief Investment Officer of Ariel Investments, the largest minority run investment firm in the US. A question and answer format was used, with Kerry Jordan, CFA, Chairman of the CFA Society Chicago, posing questions to Mr. Rogers.

In a wide-ranging question and answer session, Mr. Rogers responded to questions concerning the role of the Board of Directors of public companies, investment committee best practices, the best measure of investment success, and the current state of the market.

Mr. Rogers, who currently serves on the Board of Directors of Exelon and McDonald’s, stressed that board members must act as independent agents and have knowledge of who the outside shareholders are. Board members need to ensure that outside shareholder concerns are being heard. He argues that board members become more valuable the longer they serve; making term limits a bad idea.

Mr. Rogers’ thoughts on what “best practices” should be for Investment Committees can be summarized as follows:

  • Small size
  • Limited role (trust management to make day to day decisions)
  • Include independent thinkers

Investment performance needs to be monitored; however Mr. Rogers stressed that successful short-term performance does not mean that you are outperforming.  More than a three-year track record is required.

When asked about his key thoughts about the current market Mr. Rogers stated that this is a stressful period similar to 2008-09 and that during this period, it is important to keep in touch with “thought leaders” to see what they are thinking.  Analysts must remain free to recommend anything even though it may be out of favor.

Mr. Rogers stressed that the city culture of Chicago is one of “giving back”.  The Ariel Community Academy is a school in Chicago that fosters financial literacy.  This is knowledge that is sorely lacking, especially in minority communities.  Mr. Rogers, who became interested in stocks at an early age, thinks it is important to get kids to think about stocks.

Questions from the audience centered on active versus passive management and the future of mutual funds.  Mr. Rogers believes that a large portion of any portfolio should be in index funds and wondered how hedge funds can outperform in this market given their fee structure.

Mr. Rogers also believes that despite the emergence of ETFs and other investment instruments, there will always be a role for mutual funds in any portfolio.  There is a role active management can play.  Mr. Rogers concluded with the thought that he is optimistic on the market and there are big bargains out there to be found.

Distinguished Speakers Series: Kyle Bass

China has been in the news lately, and for all the wrong reasons.

“A hard landing [in China] is practically unavoidable,” legendary hedge fund investor George Soros told Bloomberg while attending the annual World Economic Forum meeting in Davos. “I’m not expecting it, I’m observing it,” he said.

The Chinese government, facing malaise from many angles, issued a swift rebuttal to the investor responsible for “breaking” the Bank of England in 1992, saying that “Soros’ challenge against the renminbi and Hong Kong dollar is unlikely to succeed, there is no doubt about that.” The People’s Daily, China’s Communist Party’s official newsletter, went a step further with the anti-speculative rhetoric and ran an article titled “Declaring war on China’s currency? Ha ha.”

You can add hedge fund manager Kyle Bass to the growing anti-renminbi chorus. Linking the current trouble in China’s stock market to origins in its banking system, Bass gave a sweeping overview of China’s banking system, its growing book of non-performing loans and the potential impact of a Chinese currency devaluation on the global economic system.

Kyle Bass, founder of Hayman Capital, came to the financial world’s attention in 2007 as one of the first financiers to make a fortune on shorting low quality pools of mortgages. The short subprime bet earned him a massive 212% return that year. Further public recognition came from Michael Lewis’ 2011 book Boomerang which examined how cheap financing around the world led to the global financial crisis. It featured Bass prominently as an investor who confidently understood what was going on, and was able to capitalize on it. One anecdote in the book described how Bass bought a million dollars’ worth of nickels from the Federal Reserve, with the belief that the meltdown value of the metal was actually worth $1.36 million. How did he explain the strange, enormous purchase of nickels to the Fed?

“I just like nickels,” he allegedly told them.

Before his speech, Bass quizzed luncheon attendees at the VIP table with the seemingly innocuous question: “Who knows how big the Chinese banking system is?” As we sat there stumped, he laughed and said “Come on, you’re CFAs, you should know this!”

Kyle Bass 1

Kyle Bass, Hayman Capital, speaks to local financial professionals at The Standard Club on January 26, 2016.

After a brief lament about the lunacy of visiting Chicago in January, Bass quickly cut to the chase with his thesis: China will go through a non-performing loan cycle, and the People’s Bank of China will be forced to devalue their currency. Hardly anyone knows how big the Chinese banking system is, Bass said, and understanding its size and the volume of non-performing assets relative to GDP is key to understanding the direction of the Chinese currency.

Just how big is the Chinese banking system? According to Bass, there are $30 trillion in bank assets on the books, and another $5 trillion in assets off the books, for a total bank asset to GDP ratio of 350%. This is roughly double the level of US banking assets to GDP before the financial crisis. If non-performing loans reach 10% at Chinese banks (that level was as high as 30% in 2001), that would represent a loss of $3 trillion, which is roughly the total level of China’s foreign exchange reserves held at the People’s Bank as of January 2016. China’s currency reserves continue to shrink as capital flows out of the country, and its central bank recorded the largest ever drop in reserves ($107.9 billion) in December 2015. If only 4% of Chinese citizens were to withdrawal the maximum $50,000 allowed, that would vaporize the entire pile of China’s $3.3 trillion in FX reserves. Many elite Chinese are already taking capital out of the country as quickly as possible and are looking to buy real assets with cash flows such as movie theaters, hotels and properties in Vancouver.

The capital flight out of China takes place at a time when China is experiencing its lowest year-over-year growth since 1999, and may actually be as low as 3.6% (Hayman Capital’s estimate). Bass sees six distinct crises currently taking place within China:

  1. A stock market crash
  2. State-owned enterprise transformation
  3. An export-led industrial economy facing a shaky transition to a service-based economy
  4. Declining excess reserves
  5. Property problems
  6. Lack of confidence in the government’s ability to solve the above problems

If non-performing assets rise, that will require a recapitalization of China’s banks, which will stymie new loan creation and push the central bank closer to a large Chinese Yuan devaluation. The devaluation may exceed 15%, and Bass believes that it will likely take place overnight, as a last resort by the bank once its back is up against the wall.

What does that mean for the American investor? A hard landing in China could sap as much as 100-150 basis points from GDP from the US, according to Bass. Although US stocks may decline, Bass doesn’t forecast a huge crash, but there certainly will be deflationary pressure coming from China as a result of the devaluation. The best way to play a potential currency devaluation is by shorting Chinese renminbi, but this is a difficult exposure for an American retail investor to achieve. The best available proxy to individuals may be Hong Kong assets, which are more liquid and tradeable.

Regarding commodities, Bass believes that we are close to a bottom. He drew a line in the sand for oil and said that “a drill bit doesn’t hit the ground at $25”. Bass thinks that the CRB Index may bottom within a few months, but it would not be a good idea to go long oil ahead of any Chinese currency devaluation. The aftermath of that event could represent an attractive opportunity to add to commodity longs. The supply side will resolve an imbalance on its own as lower price levels make it unprofitable to mine and drill, but the demand picture is harder to assess. Bass is unsure how commodity demand in China, a top consumer, would be affected by a large currency devaluation. He thinks bonds still look relatively attractive despite their low yields.

Bass finished his speech with a story about a meeting between former Chinese president Hu Jintao and George W. Bush. It was difficult for the two leaders to get time completely alone. In the moment they had together, Hu Jintao privately confided to Bush that his biggest fear was “creating 20 million jobs a year”. This may prove problematic for China’s current administration as it faces its biggest test yet.