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

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

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

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

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

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

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

Distinguished Speaker Series: Richard Driehaus, Driehaus Capital Management LLC

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

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

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

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

Mr. Driehaus shared the following market insights:

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

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

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

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

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

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

Distinguished Speaker Series: Charles Evans, Federal Reserve Bank of Chicago

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Charles Evans, President and Chief Executive Officer, Federal Reserve Bank of Chicago (Photo courtesy of Ping Homeric)

Charles Evans, president and chief executive officer of the Federal Reserve Bank of Chicago, addressed approximately 250 members and guests of the CFA Society Chicago on Thursday, February 9th at the Standard Club. The event was also webcast for those who could not attend the luncheon. Mr. Evans spoke about the U.S. economy, fiscal stimulus and monetary policy. He completed his presentation with responses to questions from the audience.

Mr. Evans expects a modest acceleration in economic growth to the 2.0% to 2.5% rate, and a rise in inflation to near 2.0% over the next several years. As a result, the Fed’s most likely course of action is three 0.25% increases in the Fed Funds rate in each of the next three years. These increases would elevate this rate to near 3.0% by the end of 2019. The primary risk to this outlook is that inflation does not rise to 2.0%.

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Chicago Fed President Charles Evans and CFA Society Chicago Board Members (Photo courtesy of Ping Homeric)

Fiscal policy could positively impact growth by near 0.25% a year. Lower tax rates might contribute to higher growth over the intermediate term. Additionally, optimistic consumer sentiment, resulting from healthy employment data, should contribute to growth. Average monthly gains of 180K employees over the past year have reduced the unemployment rate to 4.8%. A constraint has been business investment during the recovery, which shows no real sign of improvement.

Mr. Evans expects a decline in the unemployment rate to 4.25% by late 2019. His forecast is slightly lower than Fed’s consensus of 4.5%. The natural rate appears to be near 4.7%. A decline to the 4.25% to 4.50% range would suggest a Fed move from ease to neutral to tightening over the next several years. The downside risk to this outlook is weak foreign economies. The upside would be a greater boost from fiscal policy and regulatory ease.

Inflation has averaged 1.5% since 2009. The “Core” rate has moved up to 1.7%. Mr. Evans expects core inflation to reach 2.0% over the next three years. The downside risk is low global inflation and a strong dollar.

The structural equilibrium neutral Fed Funds rate has fallen to a lower level. Low interest rates, throughout the world, provide the central banks with less room for ease in the next downturn. The Fed has typically lowered the Fed Funds by greater than 5.0%, during easing periods and currently believes that the neutral rate is near 3.0% (1% real and 2.0% inflation). Therefore, they may not have as much room to lower rates during next recession. The secondary tools would be quantitative easing and guidance for how long rates would remain low. These non-conventional methods are “second best” to the ability to lower rates.

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Distinguished Speaker Series featuring Charles Evans

 

From 1960 to 2000, the economy grew at a 3.5% annual rate. Post 2000, the growth rate has been lower. The labor force participation rate has fallen over the past 15 years; because of retiring baby boomers, passing the peak inflow of women into the labor force, and a falling rate of employment for 18 to 24-year-old individuals. The potential real GDP growth rate has probably fallen to near 1.75%.

During the questions and answers segment, Mr. Evans addressed the following topics:

  1. CFA-Society-Cindy-Anggraini-from-Indonesia-010917-PingHomeric-0G1A5073

    President Charles Evans responds to questions from the audience.              (Photo courtesy of Ping Homeric)

    Long-term interest rates have risen 0.50% since the election, suggesting that the markets expect some positive impact from fiscal and regulatory policies. He noted that changes in tax policy (i.e. eliminate deductions, border adjusting tax, etc.) can be disruptive in the intermediate term, even though positive in the long-term.

  2. The Fed’s balance sheet grew from $800 M to $4.5 T. Eventually, this level is likely to fall back to near $1.5 T. The Most likely path would be through not re-invest principal payments.
  3. The impact of technology on productivity was apparent in 1995 to 2005 data. Since then, it has not been. He referenced the “gee-wiz” nature of more recent new technologies and quick obsolescence.
  4. The Fed chose not to use negative interest rates, even though the Taylor Rule suggested -4.0% at the low point. The Fed chose quantitative easing instead- sold short bonds and bought long. He noted some positive effect in Europe, which could influence future Fed boards.
  5. Finally, he noted that more global trade is better, provided it’s fair. Trade increases competition, which encourages higher productivity. The United Kingdom is likely to face a complicated period ahead to exit from the EU and establish new trade agreements.

Distinguished Speaker Series: Will McLean, CFA, Northwestern University

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The Endowment Model in a Low Return World

On January 24th the Distinguished Speaker Series held its first luncheon of the year welcoming one of our own, Will McLean, CFA. Mr. McLean is Vice President and Chief Investment Officer at Northwestern University, and is responsible for managing the University’s $9.7 billion endowment portfolio. Mr. McLean gave an engaging presentation to a sold out crowd over lunch at the W City Center.

Mr. McLean’s presentation centered on the challenges endowments face given the low expected return environment. McLean explained that Northwestern University follows the Yale Model of endowment investing. The Yale Model is an investment philosophy developed by David Swensen, the Yale University Chief Investment Officer. This model deviates from the traditional asset classes (stocks, bonds, and cash) and uses modern portfolio theory to invest in alternative and non-liquid assets in the form of private equity and hedge funds.

Mr. McLean laid out five principles used to manage the University’s portfolio:

  1. Diversification – this concept is straightforward. As a portfolio becomes more diversified there is typically less correlation, and the risk of the portfolio is reduced. McLean advised issues could arise if a portfolio becomes overly diversified. Excessive diversification spreads capital thinly and causes an excellent investment to impart a marginal influence on the total value of the portfolio. Over diversification could also cause investment standards to be lowered – when anything can be added to the portfolio, standards are more likely to loosened.
  2. Equity oriented portfolios need to provide a higher than average return. Given the makeup of the portfolio and the annual needs of the University, the expected return of the portfolio is in the 7-8% range.
  3. Take advantage of the illiquidity premium. The time horizon of the University’s portfolio is near perpetuity. Therefore, it is reasonable to invest in illiquid / inefficient markets.
  4. Use active managers – invest in stock pickers in the right markets. Northwestern’s investment management team and board of trustees believe active management adds value, and more uncertainty should be good for active management. Different asset classes offer different dispersions. It makes little sense to invest in the large cap equity space when the difference between the top and bottom quartile manager is not significant. Seek out alternative asset classes with bigger dispersions of returns.
  5. Ensure that your manager’s interests aligned with your own. When engaging in manager selection find out who owns the investment management firm that is under consideration. What is the owner’s motivation? McLean advised that it had been his experience that when a manager takes their firm public with an IPO, the manager’s performance underperforms. Their motivation changes from client enrichment to self-enrichment.

Due diligence should also take into account other aspects besides the manager’s performance record. Consider the internal split of management fees; do they flow to a select few individuals? How much career advancement is available to junior employees at the investment firm?  Are employees likely to be nurtured and grow or leave the firm? Negative answers to any of these questions the long-term viability of the manager to produce alpha.

DSC_3299Once his prepared remarks were concluded, Mr. McLean took a number of questions from the audience.

How do you manage board expectations of returns?

Many board members are former money managers, thus they are well versed in the risk vs. return dynamic, and they have rational market expectations.

How do you manage spending over bad returns?

There is a spending policy, which is a board level decision. The portion of the University budget funded by the endowment does not vary much from year to year.

Does Northwestern University take a view on asset allocation?

The University does not believe in market timing or tactical investing.

What is the thought process of the allocating AUM to the hedge fund asset class?

The University’s current allocation is for a 20% weighting to hedge funds. In general, 1/3 goes to long/short, and 2/3 goes to uncorrelated macro and market neutral strategies. Overall Northwestern University views hedge funds as an uncorrelated piece of the portfolio.

How does one incorporate human phycology / behavior into choosing an investment manager?

The University has a standardized approach for manager selection. Behavioral patterns at the manager firm are collected and evaluated. The manager selection team has been trained (by outside sources) to ask the right questions during the interview process, and to evaluate the manager’s non-verbal answers. Current and former employees are also interviewed for their points of view. Overall, you must train yourself to consider the all aspects of the manager’s answers and behavior.

Vault Series: Melissa Brown, CFA, Axioma

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Managing risk, specifically equity market risk, was the topic of CFA Society Chicago’s new Vault Series on January 11. The series brings noted investment experts to Chicago on a bi-monthly basis to share their thoughts and insights on the investment scene. The name comes from the common-area conference room in the Society’s new home at 33 North LaSalle Street, a space that was, indeed, once the safe deposit vault for a bank. The latest flat screen video monitors hang over the bare steel safe deposit boxes still line the walls. The day’s speaker was Melissa Brown, CFA, Senior Director of Applied Research at Axioma, a provider of risk management and portfolio analysis models and tools serving asset managers and institutional investors. Brown provides perspective and insight on market risks as measured and quantified by Axioma’s data and analytics.

Brown began by noting there are many types and measures of risks (e.g., Value at Risk, standard deviation, credit risk, liquidity risk, etc.) but Axioma defines it as the expected volatility of a market (they focus on equity markets) over a defined investment horizon. It is a function of volatility and correlations, both of which they see as being persistent over time, and therefore possible to forecast from the past. Currently, Axioma sees benchmark risks as low, but volatility is unlikely to decline further. In 2016, volatility declined in most equity markets around the world, despite a jump in mid-year following the “Brexit” vote. This was more pronounced in U. S. markets than other countries, and also in developed markets more than emerging markets. The level of volatility at the end of the year was not materially different from levels in 2000.

Axioma decomposes risk by looking at five components:

  • Portfolio holdings (generally are they more or less risky?)
  • Characteristics of the holdings (sector, industry, cap size, etc.)
  • Security-specific risks (which rose in 2016)
  • Factor volatility (an important component in Q4)
  • Correlations

The last one, correlations, is very low now and is the reason market volatility is low despite the relatively high volatility of individual securities.  Sector also plays an important role here. In the U. S. in 2016 there was a wide dispersion of risks and returns by sector. Consumer discretionary, Technology, Energy, and Materials all did well with declining risk. Finance, real estate, telecom, and utilities had very mixed results, but also with generally lower risk (except for finance). The dispersion of sector returns peaked in November at levels near records for Axioma’s database. Brown pointed out that the low correlations could provide an opportunity for active management to outperform passive.

Taking an international view, Brown noted that as of the end of the year, risk in developed markets is highly concentrated (see Italy, Greece, and Iceland) while in emerging markets, risk is more widely (and evenly) scattered. This situation developed during the fourth quarter and reflects the strength of the dollar, which is more of a challenge for emerging markets than for developed. Switzerland just nudged out the U. S. for the lowest risk by country at year end. Mexico holds the distinction as the riskiest country, again reflecting the weakness of the peso since the U. S. election.

Distinguished Speaker Series: Dan Clifton, Strategas Research Partners

“Angry is the New Hope” was the title and theme of the presentation on December 6 from Dan Clifton, Partner and Head of Policy Research for Strategas Research Partners. Hope was the watch word of the Obama administration, but the surprise election of Donald Trump reflects anger in the electorate. This anger stems from the persistent, subpar economic growth since the end of the financial crisis. In the eight years since, growth in GDP has averaged just 2%, versus the long term trend of 3%. That 1% annual shortfall, has created a cumulative GDP gap of $2.6 trillion dollars. The support that Bernie Sanders received late into the campaign indicates the voter anger extends across the political spectrum, not just within the Republican Party.DSC_3255

While Donald Trump’s election may have surprised many people, beneath the surface there were several indications that he would prevail:

  • Audiences for the Republican debates were three times what the Democrats attracted in 2008, the last time there was an outgoing administration. Ratings for these debates were even greater than popular reality television shows suggesting a great interest in making changes in Washington.
  • Weakness in the U.S. equity markets in the three months leading up to the election has a reliable history as an indicator for a loss by the party in power.
  • The finance and energy sectors outperformed the broad market in the last three months, also predicting a Republican win.
  • Support for populist, “non-traditional” parties, is gaining momentum around the world as confirmed by the Brexit vote in the United Kingdom. The push for change is global, not limited to the U. S.

This global shift toward populism is creating an urgency for governments to get their economies moving faster again. Hence, the victory for Donald Trump. Clifton listed several areas of emphasis for the new Trump Administration:

  1. DSC_3257Greater geo-political risk—as we have already seen from the phone call to the President of Taiwan, Trump has little concern for protocol and his use of Twitter increases the chance of off-the-cuff communications.
  2. Trade Policy—Trump made bold changes to trade policy a key part of his campaign and as president he will have the power to enact many of them unilaterally. Will he do so without seeking the guidance of his advisors or the congress?
  3. Fiscal Policy—the financial markets have quickly priced in everything Trump promised to do during the campaign (witness the sharp increase in interest rates and stock markets). In reality congress is unlikely to give him everything he wants and, even that, more slowly than the market expects. In particular, congress is likely to be more concerned about increasing the budget deficit than will be the president.
  4. Tax Reform—done correctly, tax reform (unlike a tax cut) will be neutral to the deficit in the early years, but achieving it is difficult and slow. True tax reform has only been done once before (1986).  A key question is whether it’s done via budget reconciliation, which is very partisan and leads to compromises that reduce the effectiveness, or dynamic scoring which accounts for the stimulating effect of the reduction in tax rates. Clifton called repatriation of foreign earnings the crown jewel of tax reform with a forecast of a potential $1 trillion coming into U. S. over fifteen months. This will add to the stimulus impact from tax reform and fiscal spending.
  5. Stimulus spending—also difficult to get done quickly–see Obama’s disappointing efforts in 2009. Clifton thought infrastructure stocks had run up too far, too fast since the election and that energy-related projects will get the emphasis from president Trump. He is likely to give a green light to several dozen projects currently being held up by the Obama administration over global warming concerns.

Trump made repealing Obama Care a signature feature of his campaign but the Republicans in congress are unlikely to repeal it without a viable replacement (which they don’t yet have). More likely they will start by cancelling the surtaxes included in the plan. This will provide a little more stimulus.  The Dodd-Frank law is likely to remain in place, but will also face revisions.

Finally, Clifton predicted that lobbyists will enjoy increased influence in the new administration. Trump will be much more susceptible to their approaches because he is not the ideologue that Obama is.

In response to questions, Clifton predicted that James “Mad Dog Mattis will get the waiver of the seven year rule to allow him to take the Secretary of Defense post and he will be a tough negotiator in that role. As a consequence, David Petraeus (another former general) will not become Secretary of State.

There are several big hurdles in the road to tax reform. One is whether to enact “border-adjustable taxes” (also called the out-sourcing tax) that would prohibit companies from deducting the cost of imported goods from taxable income. This would hurt import heavy industries (like retailers) and help exporters.  Momentum seems to be in favor of it, but it would likely draw a challenge from the World Trade Organization.

The second hurdle is a restriction on using repatriated foreign earnings for share buy-backs.  While it would enjoy political support, it would be very difficult to enact, as money is fungible. It would also be counterproductive by reducing the amount repatriated, and limiting the capital gains take from buybacks.

To the last question about raising the debt ceiling, Clifton called this an under-appreciated, but very important point. It will have to be addressed by this summer and could interfere with the tax reform efforts.

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.

 

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

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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.