Distinguished Speaker Series: Ari Paul, CFA, BlockTower Capital

It was an inauspicious day for a cryptocurrency discussion. With many cryptocurrencies down by over 10% on August 8th, Ari Paul, CFA, CIO of BlockTower Capital, gave CFA charterholders a crash course in blockchain technology and the various cryptocurrencies available for investors.

Paul said that surprisingly, many risk management professionals such as himself were among the biggest proponents of cryptocurrencies. Risk skills are definitely helpful for evaluating and investing in digital assets such as Bitcoin, and Paul believes that the space sits at the intersection of game theory, cryptography, computer science, economics, venture capital and public markets. He said that very few individuals have all of these skills, and that there is a big opportunity for people with just a small amount of cryptocurrency knowledge to generate large returns because most people don’t know much about the space yet. He compared investing in cryptocurrencies today to investing in stocks pre-Benjamin Graham. Although the idea of the blockchain is not exactly new (Paul pointed to patents received by IBM back in the 1970s for distributed databases), the current digital coin offerings such as Bitcoin, Litecoin and Ethereum are all under a decade old.

The big question when considering how to approach cryptocurrencies is “What are these helping and why do we need this?”

Paul said that a big part of the need stems from banking and capital markets technology being incredibly obsolete. He cited the examples of ACH bank transfers taking 4 days to process and $35 fees for international Western Union transfers being an opportunity for cryptocurrency disruption. While the internet has greatly increased the speed of messaging and email, payment transfers have not seen the same amount of development.

There are 3 main enhancements to the original ideas of distributed databases that have greatly increased the interest in digital currencies and blockchain lately:

  • Proof of work mining, which ensure skin in the game
  • Public key cryptography
  • Permissionless blockchain

A simple definition of blockchain could be a type of database that has its transaction entries linked with cryptography, the art of solving codes. Cryptocurrencies are the intrinsic, tradeable tokens of blockchain and the most commonly known version is Bitcoin, which had over $100 billion in market cap on the day of this presentation. Intrinsic tokens can be spent on monetary transmissions (Bitcoin) or on decentralized computing power (Ethereum). There are also asset backed tokens that can be created by a third party.

There are over a thousand digital coins tracked by coinmarketcap.com, but Paul said that the use cases and value propositions of most of them can be described in terms of three distinct categories:

  • A censorship-resistant store of value – “digital gold” or a “Swiss bank on a phone”
  • Utility tokens – amusement park tickets or paid API codes
  • Tokenized securities – crypto versions of traditional asset ownership interest

Paul said that the Initial Coin Offering market, or ICOs, has exploded in the past year, becoming larger than the overall seed stage VC market. “Many people, including myself, are skeptical of the ICO business model,” Paul said, saying that ICOs are like “hot potatoes” that speculators will often try to offload on unsuspecting get-rich-quick hopeful investors, saying that they can be seen as analogs to Chuck E. Cheese tokens.

In terms of how investors are accessing cryptocurrencies, Paul said that “we’re transitioning from crypto being un-investible [by most] to far easier,” mentioning Coinbase and other exchanges that have greatly risen in stature over the past couple years. While individuals have an easier time of buying digital coins such as Bitcoin, it is still difficult for institutional investors to access them because there aren’t many good custody options. Paul thinks that major custody bank State Street may be as far as three years away from launching a viable cryptocurrency custody product. There is also a high degree of risk of theft with the coins, and even a sophisticated investor such as Paul believes that his firm will ultimately lose money from a collapsed exchange, such as the hack of Mt Gox in 2014. Other factors limiting institutional participation in crypto include operational risk in handling the assets, the lack of credible managers with 2+ year track records and the absence of well-constructed, low fee passive indexes.

Despite the 2018 meltdown in cryptocurrency prices, Paul appeared sanguine about their long term prospects, noting that every 2 years or so there has been a large boom-bust cycle in the space, and that the potential for growth is still enormous. While Bitcoin is “already obsolete from a technology perspective” according to Paul, it still commands a widely-known brand name in the space and there’s still a huge amount of investment by institutions such as CBOE and Square. It’s difficult to know which cryptocurrency will win out in the future, but Paul believes that an allocation could make sense for some investors that can be patient riding the frequent ups and downs of the digital coin landscape.

Distinguished Speaker Series: Dean Harrison, Northwestern Memorial HealthCare (NMHC)

On June 14th at The Chicago Club, Dean Harrison, president and CEO of Northwestern Memorial HealthCare (NMHC) shared his story of leading a local organization from good to great. Since taking the helm in 2006, he has led a powerful transformation. Already boasting the top-rated Northwestern Memorial Hospital in Chicago, NMHC has significantly expanded its health system to include over 100 diagnostic and ambulatory sites and seven hospitals across Northern Illinois.

The full story, however, is much broader than just the growth of the hospital system. It is about doing so for the right reasons. It is about providing state of the art care to serve patients better. It is about research, a better academic health system, a relentless pursuit of better medicine. It reflects a vision of transforming healthcare, integrating the many parts of the system. It involves the creation and success of Northwestern Medicine. The full story reveals how to achieve spectacular results through properly applying strategy with financial discipline on top of solid fundamentals of the right culture, people and resources.

Northwestern Medicine (NM) reflects the shared strategic vision and collaboration of NMHC and Northwestern University Feinberg School of Medicine to develop a premier, integrated academic health system. NM employs 33,800 across the interconnected spectrum of healthcare, education and research with notable honors and accomplishments including:

  • Northwestern Memorial Hospital is currently the only Leapfrog A, CMS 4 Star, U.S. News & World Report Honor Roll Hospital and AA+ Rated Hospital in the United States.
  • Northwestern Memorial Hospital is consistently ranked 1st in Illinois with 11 of its specialties nationally ranked in 2017.
  • NM has the highest-ranked cardiology and heart surgery program in Illinois, (10 years running)
  • NM has the highest-ranked neurology and neurosurgery program in Illinois (11 years running).
  • Conducted 4,488 clinical trials and studies offering patients access to groundbreaking new treatment options
  • Treated nearly 1,000,000 unique patients in the past year and handled 4.7 million calls in the patient service center.

NM has over 20 years of AA-rated financial performance. This is most impressive considering the financial success occurred coincident to a tremendous period of expansion: the large investments in research, rapid growth of the health system, and consequent integration of diverse medical practices as well as alignment with academia. Never losing sight of its mission, none of the above would matter had NM not first and foremost maintained its ability to uphold its standard of exceptional care for patients.

As Harrison took us through the journey from good to great, it became clear that a focus on excellence resonated every step of the way. However, while the path was not necessarily straight, there was never any wavering on the criteria of patients first. How to deliver exceptional care where patients want to receive it was at the core of all of NM’s strategic priorities.

Staying true to the long-term strategy, supported by shorter term business plans responsive to the evolving market were fundamental to the journey. For example, the importance of having medical information available in all locations required installing an integrated electronic health record system. Doing so in the same year as opening a hospital was a particular challenge, but one that was not optional as it was imperative to introduce the new system quickly to satisfy the expectations of both patients and providers.

Throughout NM’s growth, applying a disciplined approach to expansion, while implementing a rigorous and consistent integration process was essential to achieving success. Of course, a large part of NM’s success comes from people, both within the organization and outside in its partnerships with donors and others in the community. NM instills a single culture across all of its locations and partnerships. They have made a large investment in people. Harrison commented how NMHC management is strengthened by frequent exposures to new roles and assignments within other parts of the organization as evidenced by an average of 14 years of service across senior leadership with an average of 3 years’ service in a current role. Developing people, the right culture, and nurturing resources are very important to the NM success journey.  Their upcoming priorities include:

  • Investing in fellowships and creating endowed professorships for the most promising physicians and scientists,
  • Establishing endowed and expendable innovation grants for breakthrough research and,
  • Funding scholarships for exceptional medical, PhD, physical therapy students, and nurses.

Philanthropy has been a key part of the good to great story. Areas in which achievement of NM’s strategic vision has been supported by donations while also giving back to the community in terms of jobs, improved care and outcomes in recent years include:

  • Louis A. Simpson and Kimberly K. Querrey Biomedical Research Center (scheduled for completion in 2019)
  • Lavin Family Pavilion, a new state-of-the-art outpatient facility on the downtown campus (2014)
  • New Prentice Women’s Hospital (2007)
  • Donations from longtime benefactors Suzanne S. and Wesley M. Dixon to support emerging clinical translation research initiatives, and the William Wirtz family supporting cancer research
  • New Northwestern Medicine Lake Forest Hospital just opened in March with new medical office facilities underway.

To bring it all together before taking questions,  Harrison showed a brief video about a patient with a successful outcome to a spinal injury that demonstrated the positive impact the integrated system is having on the community.

In conclusion, the good to great story of Northwestern Medicine is a collaboration of employees, students, physicians, scientists, and the community all the while keeping the interests of the patient front and center. Although the journey is continuous, NMHC has achieved tremendous recognition becoming both a local and national center for healthcare, research, education and community service.

Distinguished Speaker Series: Kunal Kapoor, CFA, Morningstar

Kunal Kapoor, CFA, chief executive officer of Morningstar, addressed a full house at the University Club on May 16. His address reviewing the current business lines at Morningstar can be summed up in his title–Serving Investors of the Future: Ratings, ESG, and Research Innovations. Most would know Morningstar as a leader in research on mutual funds, the firm’s original product, but Kapoor defined the firm more broadly as a data gatherer and analytics firm. It seeks to deliver innovative data and research to benefit investors by leveraging technology which Kapoor described as an “enabler”.  He provided the following key metrics for the firm:

  • 24 million participants in retirement plans that use Morningstar products or services
  • 12 million individual clients
  • 80% of financial advisors touch Morningstar in some way

Kapoor went on to describe in summary Morningstar’s newer services that many people would not associate with the name. The first was research in individual equities. This began following the tech bubble when institutional investors began to question the objectivity of research from broker-dealers. The environment presented an opportunity for independent research analysis that Morningstar capitalized on. It now employs over 300 equity analysts making it one of the largest independent research providers. Philosophically, the firm takes a very long-term approach a la Warren Buffet. They have even adopted his moat concept to identify companies with defensive characteristics, and as a determinant in Morningstar’s fair value calculation. To judge macro-market conditions, they have developed their proprietary Global Market Barometer (which currently reads as very slightly overvalued).

More recently the firm has expanded into credit research. This was also a response to market upheaval when, after the crisis in housing-related securities, investors viewed research from dealers, as well as the major ratings firms, with skepticism. Kapoor expects credit research to be a growth driver in the future.

Morningstar uses its data and analytics in equity research to provide indices as well. The Wide Moat Focus Index selects for firms with the widest moats in their universe and weights them according to the scale of undervaluation relative to fair value.

Morningstar recently purchased the remaining equity in Pitchbook, a data analytics firm focused on the private equity and venture capital markets, in which it previously had a minority interest. This is a response to the shrinking public equity market that is encouraging more investors to look to the private markets for new investment ideas. Data gathering and analysis is more difficult in this arena, but Morningstar intends to make it an area of focus.

ESG (Environmental, Social, and Governance) investing is yet another new product area for Morningstar. Kapoor noted that this is more than the SRI (socially responsible investing) of the past which sought to eliminate certain out-of–favor companies or sectors (e.g., gamboling, tobacco, or alcohol). Rather, Morningstar scores companies on various ESG-related metrics to identify those more likely to succeed because of their adherence to responsible policies regarding their impact on the environment and their communities. The market for ESG investing is estimated at $23 trillion and covering 26% of retail investments. Additionally, we are at the beginning of a huge wealth transfer from older to younger investors with more women making investment decisions. Both groups demonstrate a preference for investment products with an ESG focus. To address this opportunity, Morningstar has partnered with Sustainalytics, a leader in ESG research and ratings, to score mutual funds and ETFs.

Finally, Kapoor spoke to Morningstar’s processes by describing their Robotic Process Automation (RPA) effort which seeks to automate rote tasks as much as possible to improve the timeliness and reliability of products and services.  He believes there’s no activity that can’t be automated to some degree which offers the benefits of lower cost, increased scale, and improved compliance, all of which contribute to better outcomes for investors who use Morningstar’s products.

Distinguished Speaker Series: Jane Buchan, PAAMCO

Jane Buchan

The hedge fund industry has been assailed by the media as a costly, underperforming asset class, yet according to PAAMCO CEO Jane Buchan, that rhetoric simply isn’t true. On April 18th, the founder of the Irvine, CA-based hedge fund-of-funds presented to CFA Society Chicago to share her views on the hedge fund landscape.

Buchan is tired of hedge funds getting beat up in the press, and her talk both defended the industry and talked about new opportunities currently being developed. She said that the environment lately has been difficult for active equity managers and interest rates and volatility continue to remain stubbornly low. Some results of this backdrop include:

  1. Investors are focused on beta
  2. Perceived differentiation is low, causing allocators to emphasize fees
  3. Simplicity is key

The market climate has affected the hedge fund industry by giving rise to Alternative Risk Premia (ARP) strategies, which focus on fees and simplicity, and deals and co-investments, which can offer investors lower fees. PAAMCO has been active in developing risk premia solutions, which can be described as a means to access a hedge fund-like return at a lower cost with enhanced liquidity than typical hedge funds. Buchan cited Albourne’s research on ARP that shows $216 billion is invested in these types of strategies today. Somewhat surprisingly, 80% is managed by sell side broker / dealers and only 20% is managed by asset managers.

Despite the media’s negative coverage of the hedge fund industry, there is still a lot of capital in hedge funds at around $3.2 trillion, which has been growing at a fast pace. “It seems like hedge funds are the dog you want to kick,” said Buchan of the media’s view on them, saying she “suppose[s] somebody has to be the villain.” Buchan mentioned news such as the wager between Buffet and Tarrant on hedge funds outperforming the S&P 500. Given the lower market exposure of hedge funds, it is a tough bet for them to win, she said.

Considering the market environment we’re in, what’s an investor to do? “The only free lunch is diversification,” opined Buchan. One example of that is volatility strategies. Buchan said that they often look horrible on a standalone risk-adjusted basis, but on the portfolio level, adding volatility can offer significant benefits. “It’s hard when [investors] add hedge funds for downside protection and there’s no downside,” she said.

“Now let’s have some fun with data,” said the former Dartmouth professor. Buchan showed the audience a number of return histograms and asked them to figure out which asset class they were. One surprise was how concentrated the hedge fund returns were compared to high yield, which had larger tails. Private equity, also a top performing asset class, also had a much fatter tailed distribution of returns than hedge funds. One of the benefits of lower volatility is higher compound returns over time, Buchan said. This is something that current hedge fund investors are well aware of, she said, pointing to the previously referenced $3.2 trillion invested in the industry.

Another positive trend for the hedge fund industry can be found in corporate 10k filings. Buchan said that PAAMCO has been tracking them and has found that corporate defined benefit pensions are moving cash from private equity into more liquid, alpha strategies such as hedge funds. Like all asset classes, there will be periods where hedge funds underperform and outperform, but there is still a lot to like given their high return to risk ratios compared to other asset classes.

Lastly, Buchan encouraged attendees to support women in finance with the organizations Women Who Invest and 100 Women in Finance. Despite a number of studies showing that women can often make superior investors than men, Buchan said that some research indicates that a female hedge fund manager must outperform a male counterpart by 150-200 bps in order to achieve the same level of AUM.

Distinguished Speaker Series: Rupal Bhansali, Ariel Investments

Rupal Bhansali was the featured guest speaker at CFA Society Chicago’s March Distinguished Speaker Series luncheon held at the Chicago Club. Bhansali is chief investment officer and portfolio manager of Ariel Capital Management’s international and global equity strategies. Her presentation was called The Power of Non-Consensus Investing.

Bhansali began with two examples of non-consensus thinking: the micro-lending phenomenon that has helped eradicate poverty in places like India and the rise of Silicon Valley business model that was radically different from what was conventionally accepted. These examples highlighted that non-consensus thinking can be applied to a variety of situations and disciplines, including investment management. Also, this type of non-consensus thinking can drive alpha in investment portfolios. Considering the non-consensus aspect of your research is a great way to determine if there may be alpha.

The aim of institutional asset management is to be correct – correct in your assumptions, correct on your earnings estimates, correct with rates of growth. The problem with being correct is that it gets you to the same place as other good investors. A research analyst that is correct along with the rest of the institutional market is not necessarily rewarded. Fundamental research is about finding alpha, which in most cases is akin to proving everyone else wrong. Being correct and non-consensus provides rewards. The question then is how to be behaviorally different but remain analytically sound?

Bhansali provided an example of applying non-consensus thinking to the investment prospects of a global tire company. The consensus view of this company (and tire industry) was that tires were a conventional part of a car, low tech in terms of manufacture (it is just rubber and steel bands right?), and that the market is driven by new car sales. That view seemed reasonable, certainly a consensus view at the time. She then offered a non-consensus view. Is the manufacture of a tire a simple process that can be copied by a competitor? Turns out no, tire manufacturing is an involved process that cannot be easily reverse engineered. Do consumers consider tires interchangeable? No – they have brand affiliation. The consumer also cares about safety, fuel economy, and performance, which provides the company a value proposition. What drives this market is miles driven, not new car sales. A sector and business that was consensus branded as a low tech, interchangeable auto part, turned out to be a high tech, branded, mission critical good. If you had a non-consensus view on this market/brand, outsized returns were made.

A second example of a non-consensus investment view was provided on the mobile phone market. There was a time when BlackBerry and Nokia were market darlings. In part, these views were based on advanced technology, great user experience, superior growth, and competitive product advantage. The market took those factors to be insurmountable barriers. In fact these companies suffered from an eroding advantage where their products were surpassed by other brands. Apple seized the opportunity to displace these companies with a better product and user experience, offering the market exceptional growth of its own – for a time. Bhansali remarked that the consensus view on Apple has been positive for too long. Apple also suffers from many of the factors that doomed Blackberry and Nokia: alternative options and equivalent user experience for a cheaper price. She also noted that the iPhone is the dominate driver of revenue for Apple. If iPhone sales falter, Apple returns will suffer.

Bhansali’s last example of consensus/non-consensus thinking was particularly pertinent to the audience. Currently passive management is the go to option for investors. It is consensus – low entry cost, simple, easy, a no-brainer decision, while active management exhibits high costs, might have hidden risks, and is an active decision. Seems like there is no hope for active management given this view. Passive management and ETFs are winning and the outlook for active management is bleak. However, what would a non-consensus view of this subject consider? Although passive management is low cost, it is not low risk. Passive management has come of age in a prolonged bull market. It has not been stressed in a recessionary, or bear market. What might occur when large passive funds try to liquidate at the same time? For starters, the bid/ask spread will widen – a crowded trade is a risky trade. The scale that helps keep the cost of passive management low also exposes it to be too big to liquidate. A non-consensus view of active management might consider that the ease of ETF investing doesn’t equal being right, that real active management pays for itself when true active management is identified with active share, fundamental research, and management that has skin in the game.

The audience then offered some questions to Bhansali:

Q: If you believe that alpha is everywhere then the universe of securities is huge, how do you screen down to a manageable amount of securities?
A: Start from a rejection perspective not a selection perspective. Good securities will be the residual.

Q: In your portfolio what type of downside protection do you use or recommend?
A: I do not use derivatives as they are too short term in nature, and one must get the timing and thesis right for them to be effective. Protection can be obtained via investment ideas – using securities that have low correlation with the portfolio.

Q: What makes a great research analyst?
A: Bhansali noted that although it less common today, that being a generalist was helpful to her evolution as a research analyst. She also advised that a good analyst should follow multiple sectors, and always examine the counterfactual – understand what will cause a company to underperform as much as you understand the factors of outperformance.

Don Wilson, DRW Founder, on Why Cryptocurrencies Will Change

Over 200 professionals joined CFA Society Chicago for the February Distinguished Speaker Series luncheon at the W in Downtown Chicago to hear Don Wilson opine on one of the most popular topics in the financial industry today—the $450 billion cryptocurrency marketplace. The mood was focused and inquisitive, as Wilson, the founder of DRW Trading, doesn’t make public appearances often and rarely talks about the relatively new financial asset class of cryptocurrencies. Wilson’s vast knowledge in the relatively lesser known field can be attributable to researching the marketplace since early 2012 and eventually forming Cumberland in 2014, a subsidiary of DRW Trading, to provide market making services as well as hold principal positions in crypto coins and tokens. Today, Cumberland is one of the largest OTC liquidity providers in the cryptocurrency market.  I believe it is safe to say that Mr. Wilson was one of the earliest to have a vision of what a world of cryptocurrencies could look like, which makes his view on the future of this space very interesting.

Wilson echoed that in 2017, an inflection point was reached in the cryptocurrency market.  Bitcoin rose from $963 at the beginning of 2017 to close the year at $14,679—a roughly 1,500% increase that largely took off in the final quarter of 2017. In September of 2017, the CBOE and CME launched futures contracts for Bitcoin giving the asset a much larger and more sophisticated institutional audience. Even the most novice cryptocurrency investors – including those family members talking about it over the holidays —were talking about the price of bitcoin and the hottest new cryptocurrency they got wind of. Although we should pay close attention to the price of bitcoin because it was the first pioneering technology and currently is the largest coin by market cap, Wilson argued that by only doing so we would be missing the bigger picture of cryptocurrencies. The marketplace would also agree with his point.  For reference, in 2013, bitcoin made up 95% of the overall market cap of the cryptocurrency market. Today that number is closer to 40% of total crypto assets.

The technology behind Bitcoin known as the blockchain is predicated upon a framework that enables the transferring of value to anyone in the world without having to go through a centralized agent, today, most commonly known as a bank. Cryptocurrencies instead operate on a decentralized and/or a distributed platform. Benefits of switching form a centralized environment to a decentralized/distributed environment is it removes the need to trust a single organization to both hold your assets and control transfers in and out of your account. The decentralized system creates a much more resilient network that could operate even if one node of the structure went dormant. In a centralized system, if for example a bank is hacked or loses data, the entire system falls apart. In a decentralized/distributed system, there are thousands of independent “verifiers of the truth”, also called “bitcoin miners” who validate transactions for the price of small transaction fees.

 

Beyond bitcoin, there are other types of cryptocurrencies called utility tokens that are the result of ICO’s (Initial Coin Offerings) which raise money with a particular purpose or intent. Wilson believes it is the utility tokens that will have the most meaningful impact on the world going forward. Some examples he noted were Iota (MIOTA) and Civic (CVC). Iota is controversial because the underlying technology of the blockchain is different from Bitcoin. The Iota token was created in an attempt to solve the problem of how machines connected to the internet communicate to one another. For example, your household appliances will eventually all have the functionality internet connection and Iota embarks on how these appliances can communicate to one another in one language. The Civic (CVC) token is another example that in intended to facilitate identity validation. For example, Civic sets out to validate the presence of someone who lives in a remote country that may not have a birth certificate let alone a bank account, but they potentially have an internet connection that can confirm identity and allow for a financial transaction to occur.

There was ample time left for questions and as expected, most questions were in regard to what we should expect for the future. Wilson said we will continue to see great institutionalization of not only Bitcoin but all utility tokens. Investors are finally coming to the realization that the blockchain technology is here to stay and can be beneficial to societies in meaningful ways. When asked if we’ll be handing in our greenbacks for electro crypto tokens, the answer was that we probably shouldn’t expect that anytime soon as they are “unlikely” to replace standard government-issued currencies. Further, we can expect greater regulatory overview going forward which may have initial negative price implications in the very near term but should be positive longer term to strengthen the element of trust in the market place. Greater regulation, further institutionalization, and a nice near-term pull back might be all I need to buy my first (or likely only partial) bitcoin.

Distinguished Speaker Series: Jeremy Grantham, GMO

Few encapsulate the time-honored principles of value investing as Jeremy Grantham, co-founder and chief investment strategist of Grantham, Mayo, & van Otterloo (GMO). On January 23, close to 400 attendees gathered at the Standard Club for CFA Society Chicago’s January Distinguished Speaker Series luncheon where Grantham gave CFA charterholders and guests alike the tools needed to spot bubbles before they burst, as well as some food for thought on the environment and renewable energy. Several hundred others watched the presentation via webcast.

“I put this talk together on Halloween which is very suitable for this topic,” Grantham said before going through some ways to determine if the market has reached a stage of irrational exuberance. He thinks that the market is racing towards a near term melt up. But first, Grantham wanted to talk about cryptocurrencies.

In a talk in 2017, he said that he expected Bitcoin to crash before the real crash of equities prices. Since then, Bitcoin has retreated from a high of nearly $20,000 down to just over $10,000, giving the first part of Grantham’s prediction some credibility. “I know nothing about Bitcoin, I just look at it as a historian would look at it,” admitted Grantham.

The question “Are we near a melt up?” kicked off Grantham’s presentation. The expression “melt up” is becoming a frequently searched term on Google, which is another sign Grantham identified as a possible sign of a bubble. The term refers to a sudden flow of cash that drives stock prices higher, often related more closely to momentum and sentiment than underlying market fundamentals. Melt ups tend to lead to their dreaded cousin, the meltdown, and are a key concern for allocators such as Grantham’s firm GMO.

Some other classic bubbles from history include the South Sea Stock bubble, the 1929 S&P 500 bubble and the Dotcom bubble of the late 90s. The 2007 housing bubble was “the best looking bubble I’ve seen,” said Grantham, admiring the chart’s perfect conical shape.

Comparing today’s price chart with prior bubbles gives Grantham some relief. Right now, the S&P 500 doesn’t resemble a classic bubble. Prices would need to accelerate by 60% in the final bull phase over 21 months for it to rank in the same league as some of history’s more noteworthy bubbles.

While markets appear to be frothy yet not quite a true bubble, it’s important to watch out for clues that can help identify a bubbly market. First we can look at the advance/decline ratio. As the ratio declines, that can be seen as anearly warning sign for the broader market, with fewer stocks carrying the market higher.

Valuation is another clue investors often look at to determine if we’re in a bubble. Grantham agrees that markets are very expensive. Looking at a modified Shiller CAPE ratio, there was only one time in history where equities were this pricey. That year was 1929, and it led to a precipitous fall and the largest stock market decline in history. While expensive, looking at price-to-earnings ratios tells you very little about the likelihood and timing of a bubble bursting, opined Grantham. He gave the example of exploding PE ratios in 1990s Japan as one example where a very high ratio led to an even higher ratio.

So if looking at valuation doesn’t work for spotting bubbles, what does? Grantham said that using indicators of market participants’ euphoria is a much better route. Margin buying of equities and outperformance of quality stocks vs high beta stocks are a couple items to explore. The US housing market also is showing some signs of bubbliness. Nobody is talking about housing looking like a bubble right now but there are definitely some signs, according to Grantham.

One absolute requirement for a bursting bubble is a Republican Presidency, Grantham said, pointing to Hoover, Nixon and G.W. Bush as some Republicans who’ve presided over bursting bubbles. Grantham said that he believes that there is a greater than 50% chance of a melt up that would bring the S&P 500 to 3200 – 3800. If so, then he thinks that there will be a 90% probability of a meltdown from there.

Climate change and renewable energy was Grantham’s second topic. “The good news is that technology is accelerating along with the damage [being done to the environment],” said Grantham. Wind and solar power are quickly becoming cheaper than coal and nuclear power. Those developments are forcing investors to consider how they are positioning their portfolios in light of climate change. Alternative energy represents “the biggest transformation since the introduction of oil”.

Oil consumption is set to peak in 2020. With many shale companies remaining unprofitable, Grantham thinks that capital will flow towards renewable energy. His firm GMO has a climate change fund that offers opportunities in this space as do a number of other investment managers. “We live in a world where chemical poisons are deeply penetrating everything, “Grantham said, highlighting reduced sperm count among men, deep declines in flying insect populations and reduced grain production as some of the many troubling signs he sees with the environment today.

Right now GMO favors Emerging Markets and EAFE stocks over US stocks and has positioned its portfolio for foreign outperformance over the next few years. Capitalism has produced its benefits, but fails to account for the tragedy of the commons, with pollution, rampant use of fossil fuels and marketing of opioids still taking place despite the harm caused to human life.

Grantham’s talk was indeed as spooky as advertised, and gave attendees plenty to mull over while considering how to position their portfolios against the backdrop of high asset prices and troubling environmental issues.

 

Distinguished Speaker Series Webcast – Jeremy Grantham, GMO

Recorded January 23, 2018

 

Distinguished Speaker Series: Myron Scholes, Ph. D., Janus Henderson Investors

Nobel Laureate and co-originator of the Black-Scholes options pricing model Myron Scholes, Ph. D., gave a crash course to a sold-out crowd on utilizing risk management over stock selection at the Palmer House Hilton on November 17th. Over 250 CFA Society Chicago members and finance professionals braved a dreary day to learn how options might be used as a predictor of market prices.

Scholes maintains that as investors pursue compound returns, tracking error and portfolio mandates constrain managers to stay close to the benchmark. Management of portfolios is left to asset allocators and active managers will hug the benchmark in times of risk. Relative performance constraints or not deviating from the benchmark is an implicit cost. The take away is that average returns produce average performance.

When looking at bell curve distributions, Scholes suggests focusing on the gains and losses in the tails to manage risk and not paying attention to the averages or the “stuff in the middle”. Every performance period matters and as time compresses, risk increases with compound returns being asymmetric. Letting risk fluctuate around an average can reduce returns. He also opined that with time diversification and cross-sectional diversification being free, time diversification is more important.

So, given all of this, how do we get measures of risk?  This is where options markets come in to provide risk prices. Per Scholes, people ignore valuable options information when they are constrained. As Scholes expanded on this theme, the audience learned about the fallacies of some of our industry’s well-known and highly utilized risk measures. For example, our much loved and used Sharpe ratio does not fit in with this thought process because it is a mean variance measure. The closely watched Chicago Board Options Exchange Volatility Index (VIX) gives correlations that are in the center of the distribution. Knowing the limitations of traditional risk measures, how can investors use option information? Back tested options information should be used to see the risk distribution allowing reallocation and management of risk in a portfolio.

The presentation concluded with a question and answer session. Attendees were clearly thirsty for information about this methodology from this industry icon and were interested in comparing it to momentum investing and other popular valuation methodologies.

Distinguished Speaker Series: Mario Gabelli, CFA, GAMCO Investors Inc.

Well known value investor Mario Gabelli, CFA, chairman and chief executive officer of GAMCO Investors Inc. and LICT Corp., addressed a capacity audience of CFA Society Chicago members and their guests at the Standard Club on September 14th. In a wide-ranging presentation, Gabelli drew on his four decades as a money manager to offer his insight and wisdom on the current state of the economy and investment markets. He began by extoling the virtues of a CFA Charter, pointing out that only through the detailed analysis of a charterholder could one understand a business well enough to see how it fits into the economy and how to value it correctly. He encouraged everyone to “keep doing what you are doing” to help our country and make capital markets work even better.

Gabelli touched briefly on two topics he believes need regulatory change. The first was ETFs and the advantage they have over mutual funds because of their tax-efficiency.

He strongly advocated for leveling the playing field with an end to the requirement that mutual funds distribute realized capital gains annually, thereby creating a taxable liability for investors even though they have made no transaction. Every other type of investment requires a sale to generate a capital gain, and mutual fund shares ought to be treated the same.

Second, on tax reform, he said Congress needs to cut the corporate income tax rate to make American firms more competitive with foreign ones.  The protracted debate is only serving to delay new investment that our economy badly needs.

Without going into great detail, Gabelli listed several sectors that he thinks currently offer attractive investment opportunities, including:

  • Infrastructure: Although this is on the top of many favored lists, he pointed out that the American Society of Civil Engineers rates infrastructure in the U. S. as D+, which will require new investment regardless of the political environment.
  • Health and Wellness: Drawing on the trend of an aging population, he recommended investments in vision and hearing care, joint replacement, and obesity treatment.
  • Live entertainment: Gabelli described this as being immune to competition from Amazon (or, more generally, the internet). Noting the high valuations put on sports teams in private transactions, he has calculated that a sum-of-the-parts analysis on Madison Square Garden Entertainment yields a value of zero for the New York Knicks.
  • Equipment rental: A secondary play on infrastructure, but one that he expects to do well even without that tailwind.

Distinguished Speaker Series: Jean-Marie Eveillard, First Eagle Funds

Value investing makes sense; it works over time, so how come there are so few of us?

On August 9th, CFA Society Chicago welcomed Jean-Marie Eveillard, senior investment adviser to First Eagle Funds, at the Chicago Club. The famed investor behind $110 billion First Eagle Investment Management has long believed that value investing can be a lonely place.

The septuagenarian still follows the advice of Warren Buffet and his predecessor Benjamin Graham. “The best book on investing ever written is [Ben Graham’s book] Intelligent Investor,” he said. Despite the sustained popularity of those pioneers today, pure value investing is becoming increasingly rare, Eveillard said.

Value investors must shun the wisdom of the crowds, and more importantly, they must be right. Sometimes value investing is fashionable, oftentimes it is not. Eveillard estimates that only 5% of the investment industry practices value investing. The limited embrace of a value tilt is partially due to the career risk portfolio managers face when choosing out-of-favor stocks. Sometimes investing in these stocks may take years for an investment thesis to play out, and asset owners are frequently less patient. The fear of losing a job causes herding into more socially acceptable stocks, and this dynamic makes it very hard for an investor to commit to value. This often tilts mutual funds towards becoming “closet indexers”, said Eveillard.

Eveillard discussed how he uses both qualitative and quantitative in his process. As a value investor, he marches to the beat of his own drum, eschewing the tactics used by marketing-focused money managers.

Jean-Marie Eveillard, First Eagle Funds

“I never spent a penny on advertising,” said Eveillard, contrasting his near singular approach to investing to more commercially-minded mutual fund companies. In his talk, which connected his years working in the industry with the thinkers that most influenced him, one area mentioned was the Austrian school of economics, particularly its 1974 Nobel Prize winner Von Hayek. Margin of safety was also mentioned, with Eveillard saying that it was the secret of strong investors.

Interestingly, Eveillard reckoned that a great deal of his success as a portfolio manager didn’t come from the stocks he picked; it came from what he didn’t own. Eveillard cited a number of examples such as Japanese stocks in the late 1980s, tech stocks in the late 90s, both of which he avoided. Eveillard was asked if he thought there is currently a bubble reminiscent of the late 1990s in today’s tech stocks, and Eveillard opined that today isn’t as bad as the dotcom bust era defined by the epic failures of Webvan and Pets.com.

Covering his use of qualitative data, Eveillard told a story about Enron, saying that he asked a research analyst on his team to look into the firm for a possible investment. The analyst found Enron’s statement footnotes incomprehensible, to which Eveillard responded that if that was the case, they’d move onto something else and wouldn’t invest.

Eveillard noted that so many of the numbers you see in accounting estimates are estimates. He said that in the late 1990s, he would often spot crafty CFOs who would observe the letter of the regulation, but not necessarily the spirit. In some ways, Eveillard said, accounting is more a reflection of a cultural mindset, with more conservative, risk-averse cultures taking earnings provisions on potentially low risk items. A good international investor needs to be mindful of the cultural differences in preparing accounting statements.

On the Efficient Market Hypothesis, Eveillard said that “it denies human nature.” He’d often debate the EMH with his academic friends and they would say that although they might agree, they needed to find a new theory before abandoning an old theory.

He mentioned the topic of moat, a means of ensuring that a company has a long run sustainable advantage. One reason that Warren Buffet rarely sells stocks is because it is hard to find companies with sustainable advantages, and once one is identified, an investor simply needs to be patient.

Given the strong outperformance of growth vs value stocks in the US over the past decade and the dearth of dedicated value investors, a change in investor mindset might be needed before value investing returns to vogue. But patient investors such as Jean-Marie Eveillard will be willing to wait it out.