ARNOTT DUMB “SMART BETA” INVESTING: ONE OF ITS PIONEERS SAYS IF THE PRICE IS WRONG IT CAN BE REALLY DUMB TRANSCRIPT
CONSUELO MACK: This week on WEALTHTRACK, financial innovator Rob Arnott of Research Affiliates warns that ‘smart beta’ investing, a popular alternative to index investing, which he helped create can go horribly wrong…next, on Consuelo Mack WEALTHTRACK.
CONSUELO MACK: Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. Indexing is all the rage…more investors both institutional and individual are abandoning actively managed mutual funds for index funds and exchange traded funds, which are based on a managed index, the most popular being the S&P 500. Since 2009 these passively managed funds have exploded, from 11% of global assets under management, to 19% last year, a 73% gain, with no slowdown in sight.
Investors are switching for two reasons. The most important being that market based index funds have been outperforming the vast majority of actively managed funds for the last decade. According to the investment classic, “Winning The Loser’s Game: Timeless Strategies For Successful Investing,” by financial thought leader and frequent WEALTHTRACK guest, Charles Ellis:
“In round numbers, over one year, 70% of mutual funds underperform their chosen benchmarks. Over 10 years, 80% underperform.”
The other major reason: index fund’s fees are much lower than actively managed ones, and they are falling rapidly. Many of them now charge just 5/100ths of a percent! Traditional index funds have their critics, however, as they’re weights based on market capitalization, which means the index is dominated by the companies with the largest stock market value. Investors end up owning the most expensive stocks, whereas smaller companies or those not appreciating as much or declining have much less of a share.
The top 10 companies by market weight in the S&P 500 for instance, account for nearly 20% of the index. They include three of the so called FANG stocks: Facebook, Amazon and Google parent Alphabet, as well as blue chip giants like Microsoft, Exxon Mobil and Johnson & Johnson.
This week’s guest is Robert Arnott, chairman and CEO of Research Affiliates, which he founded in 2002 as a self-described: “…research intensive asset management firm that focuses on innovative products.” Among the innovations that he has pioneered is what he calls Fundamental Indexation. Building indexes with stocks based on the size of their fundamentals, such as sales, profits, cash flow, book value and dividends, not their stock price.
His firm Research Affiliates has created a series of fundamental indexes for a variety of markets and asset classes around the world. The Rafi indexes were early entries in an approach to investing that has become extremely popular, known as Smart Beta. Smart beta is an umbrella term for multiple index strategies based on characteristics other than market price. As the Financial Times defines it: “…Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices.” But have they and will they in the future? Arnott and his team have recently published a series of research articles on the future of Smart Beta. A link to them is available on our website.
I asked Arnott why the shared premise of all Smart Beta strategies is that market cap weighted investing is not the way to go.
ROB ARNOTT: It’s actually really simple. If you capitalization weight the portfolio, if the share price doubles, your target weight in the portfolio doubles. Why should you want to own more of a stock after it’s doubled than before it’s doubled? If it’s an efficient market and if the pricing was correct before it doubled and was correct after it doubled, shouldn’t you want the same amount after as before? Doesn’t that mean you should be rebalancing within the equity portfolio? People rebalance their asset allocation all the time. Why not rebalance within the equity portfolio?
CONSUELO MACK: Right. And the market capitalization formula does not call for rebalancing based on price appreciation or, right?
ROB ARNOTT: Correct. So the shared attribute of true smart beta strategies is that they break the link with price, and they earn an incremental return because they contra trade against the market’s most extravagant bets. It’s that simple. So, fundamental index obviously qualifies. Equal weight qualifies. Minimum variance qualifies if it doesn’t anchor on the market sector weights or something like that if it’s pure minimum variance. Even weighting a portfolio by the number of board members who have facial hair would be …
CONSUELO MACK: So it’s anything but market capitalization.
ROB ARNOTT: Right.
CONSUELO MACK: Yes. So here’s the rub. The market capitalization indices have done really well in recent years.
ROB ARNOTT: Oh, they sure have.
CONSUELO MACK: And so, for instance, I looked at the FTSE RAFI U.S. 1000, one of your fundamental weighted indexes, versus the Russell 1000, and over the last one- and three- year periods, your index has underperformed this market cap weighted Russell 1000. How do you explain that?
ROB ARNOTT: Very simple: you have value-driven markets and you have momentum- driven markets. If momentum is on a roll, then you don’t add value by contra trading against the market’s most extreme bets. You have to be patient. And if value is underperforming, anything with a value tilt, faces a headwind. Now, what’s cool about fundamental index is we introduced the idea almost 12 years ago, FTSE started publishing the index almost 11 years ago, and it’s beat the market by just under one percent per year compounded, which is fine. That’s nice. But it’s done that while value has underperformed growth by two percent per year. Oh my goodness.
CONSUELO MACK: So explain that. How did that happen?
ROB ARNOTT: That happened because fundamental index isn’t a plain vanilla value strategy. It doesn’t simply throw out the growth stocks and cap weight the value stocks the way a conventional value strategy might. And as a consequence of that, we’re adding value from rebalancing. Fundamental size of a business is an anchor, a stable anchor that we trade towards. So if a stock soars in price and its fundamentals haven’t changed much, then we’ll say thanks for those lovely gains, I’m sure the company has a great outlook, but it’s in the price, it’s not going to help you, let me reweight it down to a second on my footprint.
CONSUELO MACK: Right.
ROB ARNOTT: And if a company is deeply out of favor trading very cheap, fundamental index will say, yes, the company is probably pretty troubled, but it’s obviously in the price and it’s a big company, so let’s reweight it back up. And it’s the contra trading against the market’s most extreme swings.
CONSUELO MACK: That explains the points, right.
ROB ARNOTT: That creates the alpha. The average value tilt contributes very little. The dynamics shifts in the value tilt, that’s where the alpha comes from.
CONSUELO MACK: Are we still in a momentum market? I mean, how long could the momentum-driven market last?
ROB ARNOTT: I think the value bear market which started in 2007, probably came to an end in January. The value has recovered all over the world. Fundamental index in emerging markets where value was hit most savagely in recent years, fundamental index in emerging markets has beat the cap weighted indexes by well over 1,500 basis points in well under a year. That’s pretty cool.
CONSUELO MACK: So, do these trends, for instance, momentum being out of favor and value coming back, are these long-lasting trends?
ROB ARNOTT: They often are.
CONSUELO MACK: Are they multiyear trends often or?
ROB ARNOTT: Think of it as a bull and bear market. Value has had a wrenching nine-year bear market relative to growth.
CONSUELO MACK: Right. Doesn’t mean you’ve lost money in value, but you’ve underperformed relative to growth.
ROB ARNOTT: Right.
CONSUELO MACK: As I said in my introduction to you that you’re a pioneer in fundamental indexation, and fundamental indexation is under what’s called the Smart Beta umbrella, which is a very popular term, very popular strategies. And you and your research team, research affiliates have written a series of papers, of research papers that are on your website and we will link to them on our website, about smart beta. And the intriguing title of the first one was “How Can Smart Beta Go Horribly Wrong?” So my first question to you is can it go horribly wrong? And has it?
ROB ARNOTT: What I’m talking about is that users of smart beta can find that the strategies go horribly wrong for them if they engage in performance chasing. And performance chasing is rife in our business. What do you look at when you’re thinking of embracing a strategy? You look at the trailing one-, three-, five-, ten-year results, and if three out of the four look good, okay, that’s the strategy for me. Pardon me, but whatever is newly expensive and vulnerable to disappointing results, is highly likely to have been wonderful in the past.
CONSUELO MACK: Especially the recent past.
ROB ARNOTT: Right.
CONSUELO MACK: Last three years.
ROB ARNOTT: So that particular paper was hugely controversial, and I found the controversy amusing, because all we were saying is look at the price. When you buy a car, you look at the price. If you’re sensible when you buy a stock, you’ll ask, what are the valuation multiples and how does that compare with what I think is reasonable? If you buy a strategy, whether it’s fundamental index or minimum variance or you name it, anything, you should ask the question, is it trading richer relative to the market than its own historic norms? A quality strategy is always going to trade at a premium. Sometimes it’ll trade at a 20 percent premium to the market, sometimes an 80 percent premium to the market. If you’re paying 20 percent above the market, go with quality. It’s cheap. If you’re paying 80 percent above the market, watch out. There might be mean reversion.
CONSUELO MACK: So which Smart Beta strategies, or which factor tilts now look really expensive to you?
ROB ARNOTT: When you look at low volatility and minimum variance and low beta strategies, if they anchor on beta to choose their portfolio, they today are trading at very high valuations relative to historic norms. So that strikes me as, I mean, they’re wonderful strategies, don’t get me wrong. But buy them now and you might be in for disappointment. Their recent results have been wonderful, and that’s why people are pouring money in.
CONSUELO MACK: Exactly, yes.
ROB ARNOTT: So what our work suggests is quite simply look at the price. The other controversial thing we pointed out is equally obvious and should be equally uncontroversial, and that’s that when people have found factors, or Smart Beta strategies, chances are they found them because they performed well.
CONSUELO MACK: Yes.
ROB ARNOTT: Chances are they found them because they had gotten more expensive. Cam Harvey wrote a survey paper in which he looked at published factors and anomalies and smart beta strategies.
CONSUELO MACK: And Cam Harvey is?
ROB ARNOTT: He’s a Professor at Duke. He found that 316 factors had been identified by the end of 2012, and 30 to 50 more were being identified each year. So we’re probably at 500 factors by now. Okay, I asked him how many of the 316 had added value? He laughed. He said 316. Okay, so was there data mining involved in finding these factors? Of course there was. Was there selection bias: you only pay attention to the best ones you find? Of course there was. Was there anything evil or nefarious about this? No, but it does mean that the forward-looking returns are likely to be worse than the past returns. I then asked Cam, how many of these authors ask the very simple question: did my strategy get more expensive during the test period? Did that contribute to the wonderful past results. And he said zero, not one out of 316 papers had asked that very simple fundamental question.
CONSUELO MACK: Simple. Right.
ROB ARNOTT: And that was viewed as a highly controversial thing to point out. Well, why is it controversial? All we’re saying is when you find a strategy, why don’t you ask how much of the alpha is revaluation, and what’s left might be structural alpha. If what’s left is large, then you found something really nice. With low volatility and with most quality strategies, revaluation has been the dominant source of return and you take that away and there is no value add left. I would also posit that if you’re paying twice as much a price for low beta as high beta, your downside risk is not lower. It’s higher. Now, there are low vol strategies that anchor on the volatility of companies, not the beta. It’s a subtle difference but an important difference. Three of the four FANGs, Facebook, Amazon, and Netflix, early this year dropped into the low beta portfolio.
CONSUELO MACK: Really?
ROB ARNOTT: Yes.
CONSUELO MACK: That’s surprising.
ROB ARNOTT: So those became three of the 20 largest holdings. All right, so …
CONSUELO MACK: Why did they drop into the low volatility portfolio?
ROB ARNOTT: Here’s what’s interesting about beta. Beta measures your sensitivity to market movements.
CONSUELO MACK: To markets, mm-hmm.
ROB ARNOTT: So if you have a stock that tracks perfectly with the market, it’s going to have a beta of one. Market goes up one, you’re going to be up one. Suppose we have a stock that’s very volatile but doesn’t necessarily track with the market. Suppose the market’s down one percent on a particular day and Facebook’s up five percent because of some news. That looks like a minus five beta at least for the day. Average it across enough days, and you wind up with, oh, Facebook’s now all of a sudden low beta because of a few anomalous days when it swung the other way, when it zigged when the market zagged. So if three of the four FANGs are among your larger holdings, I would suggest that you aren’t buying a portfolio with reduced downside risk. You’re buying a portfolio with increased downside risk.
CONSUELO MACK: Right, because they’re expensive.
ROB ARNOTT: Right. Now …
CONSUELO MACK: They know them really well. Mm-hmm.
ROB ARNOTT: There is nothing wrong with low vol. Low vol generally does what it purports to do: reduce your risk, reduce your downside risk. Watch out if it anchors on beta. Minimum variance strategies, for instance, anchor on beta. S&P’s low vol strategy anchors on volatility. Facebook, Amazon, Netflix won’t get into the portfolio. Okay, that helps. But also look at the valuation and ask, is the market pricing low vol cheap or rich? And no matter how you construct it, right now it’s trading rich. Why? Flight to safety.
CONSUELO MACK: Right.
ROB ARNOTT: People in the U.S. and all over the world have been repositioning to what they think are less risky, higher quality portfolios with the result that low volatility companies now trade at a premium multiple to high volatility companies, very anomalous, and that high quality companies trade at a premium, as they always have, but a larger premium. The revaluation is to a new normal and is based on totally justifiable reasons. That’s how smart beta goes horribly wrong: if you pile into a strategy because it has brilliant ten-year results, and it’s priced to have horrible ten-year results in the future, uh-oh, it’s nothing stupid about smart beta. It’s just using smart beta in a careless way.
CONSUELO MACK: So Rob, listening to you as an individual investor, I’m saying to myself, this is way too complicated for me. And a lot of Wall Street firms and investment advisors are trying to sell me as an individual on these Smart Beta strategies and I’m saying, listening to you, I’m saying, whoa, this is way too complicated, and also, I’m probably chasing performance, and it might be what they’re saying is low risk is going to be higher risk. So what’s my strategy as an individual? I mean, do I just avoid these new vehicles and …
ROB ARNOTT: No.
CONSUELO MACK: No. Okay.
ROB ARNOTT: No. Smart Beta is an umbrella that’s expanding. It’s been expanded to encompass all sorts of ideas. Some of them are good and some of them are bad. Some of them are good ideas that are temporarily expensive. So what you want to do is first break the link with price in your own behavior. Don’t buy a strategy just because it has great five- or ten-year results. Buy it because it’s cheap now relative to its past. Now, what’s newly cheap is likely to provide wonderful forward returns and it’s likely to have inflicted pain and losses getting to cheap. The last time we got together, I was talking about emerging markets deep value, fundamental index and emerging markets. Okay, since January, that’s up about 60 percent. Oh my goodness.
CONSUELO MACK: What do we do? So you are rebalancing out of, right?
ROB ARNOTT: I still like the asset class. It’s gone from unbelievably cheap to pretty decently cheap.
CONSUELO MACK: And you were early …
ROB ARNOTT: So I still like it.
CONSUELO MACK: … in emerging markets and …
ROB ARNOTT: I was.
CONSUELO MACK: … it hurt your relative performance.
ROB ARNOTT: Until they turned.
CONSUELO MACK: Right.
ROB ARNOTT: So the idea in contrarian investing is: if you like something because it’s cheap and it gets cheaper, buy more. That’s the only way to assure that when it turns, you have your maximum exposure at the turn, and it’s the only way to assure that in any mean reversion, any rebound, you get back the entire shortfall really fast.
CONSUELO MACK: What’s cheap now? You just said, so emerging markets stocks?
ROB ARNOTT: Emerging markets stocks are still cheap.
CONSUELO MACK: Still cheap. Relative to their historic …
ROB ARNOTT: Yeah.
CONSUELO MACK: …Range and relative to how they trade to developing markets, for instance?
ROB ARNOTT: Right.
CONSUELO MACK: All sorts of measures, yes.
ROB ARNOTT: And emerging markets deep value, best exemplified by fundamental index and emerging markets, is also trading cheap. It’s trading at what’s called a Schiller P/E Ratio, price relative to long-term ten-year earnings of eight-and-a-half, and that’s after rising 60 percent. So that means that back in January, it was trading at five-and-a-half times earnings. You could buy half the world’s GDP at five-and-a-half times earnings.
CONSUELO MACK: It’s no longer January but you still think?
ROB ARNOTT: It’s still relatively cheap. There are other things that are cheap today.
CONSUELO MACK: Yes.
ROB ARNOTT: EAFE international stocks has gotten cheaper, and value in international stocks has gotten cheaper.
CONSUELO MACK: Right, value stocks in the international space.
ROB ARNOTT: Correct. Not as cheap as emerging but still pretty good. So I’ve been called
a perma bear sometimes in my career. I’m a bear when things are expensive. I’m a bull when things are cheap. If you buy international stocks, they’re cheap. Emerging markets stocks are cheaper.
CONSUELO MACK: And when you talk about international stocks, these are in developed countries.
ROB ARNOTT: Correct. Emerging markets’ currencies have gone from 25 percent rich relative to purchasing power parity back in 2010, to 30 percent cheap back in January. And people worry that Trump’s protectionism is going to be devastating to emerging economies of the world. Bet against the conventional wisdom. He is not likely to do anything wildly stupid. He is not likely to impose 70 percent tariffs on emerging markets countries, because trade works both ways. You’d stifle your own exports if you do that.
CONSUELO MACK: So you think he will be, and I was going to ask you, as far as the Trump Presidency, how you figured that in, or does it figure into your investment outlook?
ROB ARNOTT: When the media thinks a particular outcome is highly likely, Trump will be a disaster. Bet against the media because that captures the conventional wisdom.
CONSUELO MACK: Again, you’re speaking like a true contrarian.
ROB ARNOTT: Right.
CONSUELO MACK: You’re saying if everyone is saying one thing, be highly suspicious and skeptical.
ROB ARNOTT: So we’ve seen a flight to safety, which has meant a flight to the U.S., which has meant a flight to the dollar, the dollar is newly high, what a wonderful time to move money out of the dollar into some cheap currencies. The challenge is staying the course because unless you can pick the bottom tick, you’re going to go through periods of time where you look and feel stupid for months or even a year or two.
CONSUELO MACK: Right, because you’re underperforming again …
ROB ARNOTT: Right.
CONSUELO MACK: … relative to your benchmark or whatever.
ROB ARNOTT: And if you look and feel stupid for two years and you flinch and pull back, you’ve just locked in your losses. If you underperform for a couple of years and you rebalance into a larger position, you get it all back astonishingly fast. So emerging markets currencies, I would also say, represent a very interesting opportunity.
CONSUELO MACK: And that might lead me to the one investment for a long-term diversified portfolio, would be emerging market currencies, right?
ROB ARNOTT: Yes.
CONSUELO MACK: Is that your choice?
ROB ARNOTT: Yes, yes. PIMCO’s got a great record and a great reputation in bonds and in emerging markets, and so, the PIMCO emerging markets currency portfolio. You’re not buying Tibot and stuffing them into a mattress. You’re buying Ti short maturity debt which has a beautiful premium yield.
CONSUELO MACK: Not hedged.
ROB ARNOTT: Unhedged.
CONSUELO MACK: Unhedged. Right.
ROB ARNOTT: So that if the currency doesn’t take away the entire yield premium, or better still, if the currency recovers, then you get high yield with rising valuation from the currency rising. And emerging markets’ currencies are broadly very, very cheap.
CONSUELO MACK: Rob Arnott, always a pleasure to have you on WEALTHTRACK. Thanks so much for joining us.
ROB ARNOTT: Thank you so much. This has been fun.
CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is: act like a contrarian and systematically rebalance your portfolio. That means periodically adjusting your investments back to the appropriate allocations pre-determined by you and your financial advisor. By trimming big winners and adding to substantial laggards.
Arnott adjusts some of his fundamental indexes annually and others quarterly. You don’t have to do it frequently; just have a plan to do it at least once a year to have a disciplined approach to buying low and selling high.
Next week, we will have an exclusive interview with Wall Street’s top strategist François Trahan. Why has this bull just turned bearish? We’ll find out.
In the meantime to hear why Rob Arnott chases solar eclipses in his spare time, go to the Extra feature on our website, wealthtrack.com.
Also please share your comments with us on Facebook and Twitter.
Thank you for watching. Have a great weekend and make the week ahead a profitable and a productive one.
CONSUELO MACK: This week on WEALTHTRACK, what history has to teach us about this year’s presidential election results and what they mean for the economy and markets. Noted financial historian Richard Sylla and leading investment strategist Jason Trennert are next on Consuelo Mack WEALTHTRACK.
Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. The election results are in. The uncertainty is over. In a tightly contested race, and a stunning upset, Republican candidate Donald Trump prevailed and will be the 45th President of the United States. Republicans held onto a slim lead in the Senate and retained control of the house.
As we recover from one of the most contentious elections in recent history, it might be helpful to recognize there have been other contests in this great country’s past that were even more bitter and divisive and yet the republic stands.
One of the most vicious election in the earliest days of America occurred in 1800. Alexander Hamilton turned on fellow federalist and then president John Adams publishing a pamplet calling him “…emotionally unstable, given to impulsive and irrational decisions, unable to coexist with his closest advisors and generally unfit to be President”.
Then Vice President Jefferson’s enemies accused him of being “a godless nonbeliever, a radical revolutionary… conducting vivisection and bizarre ritualistic rites at his home, Monticello.”
We’ll discuss the impact of brutal campaigns on the economy and markets with financial historian Richard Sylla in a moment.
If more recent history is any guide, since 1900 the worst market performance during an election year occurs when an incumbent party loses the presidential election, as just happened. The Dow clocked in with an average loss of more than 4% for the year. Who has political control matters too. When the White House and Congress are controlled by the same party, as they are now, the gain is around 7%. We’ll see which outcome prevails this time.
What are the market ramifications of this election? And what are the lessons to be learned from history? Joining us are two experts in the financial markets.
Jason Trennert is Founder and Managing Partner of Strategas Research Partners, a top macro research firm in economics, investment strategy and policy. Jason is considered to be a leading investment strategist and a financial thought leader.
Richard Sylla is Professor of Economics Emeritus at New York University’s Stern School of Business. From 1990-2015 he was Professor of the History of Financial Institutions and Markets there. He is the co-author of the now classic book, A History of Interest Rates and the author of the just published Alexander Hamilton: The Illustrated Biography.
I began the interview by asking Jason Trennert about the aftermath of the election – with the uncertainty over is there a sense we can get back to normal?
JASON TRENNERT: We’re not quite sure it can get back to normal that quickly, but by the same token, I think the market action recently probably had a lot to do with the acceptance speech of Donald Trump and the concession speech of Secretary Clinton, which were both in my opinion rather gracious and suggested that both sides, at least for the time being, might want to work with one another. I also that the fact that Donald Trump has both the House and the Senate probably makes his life a little bit easier in terms of getting sort of early wins in terms of getting the economy moving again.
CONSUELO MACK: Dick, put on your historian hat and there are two kind of marked features of the campaign. One was the divisiveness and kind of the viciousness in some respects of the campaign, and the other was that we had a populist candidate who just upended the Establishment. So let’s take them one at a time. Looking back historically, there have been other divisive campaigns in this country. Do they inflict long-term damage on the country? What should we expect as an aftermath of this kind of a campaign?
RICHARD SYLLA: Well, we’ve had this kind of divisive campaigns going back to the beginning of the Republic. I mean, not George Washington but under, in1796 with Adams running against Jefferson, 1800 the same thing, Jefferson and Adams, those weren’t pretty. They called each other names. And I think after the election, some of that goes away. You know, the hard feelings don’t persist except sometimes, I believe. In the election of 1824, Andrew Jackson felt cheated, spent four years angry, and then …
CONSUELO MACK: At John Quincy Adams.
RICHARD SYLLA: … yes, John Quincy Adams won and Jackson called it a corrupt bargain. And then, in 1828, Jackson win and he was very angry about it. And so, that was the case where the kind of hard feelings of 1824 persisted for four years.
CONSUELO MACK: So sometimes it can make it harder to govern, right?
RICHARD SYLLA: I think so, yes, yes, because the Jackson people were so angry, they made it difficult for John Quincy Adams to do anything.
JASON TRENNERT: Right. So what about the populist aspect? And again, the fact that this, at least analysts are saying that this was as much an anti-Establishment vote, an anti-political- elite vote as anything else.
RICHARD SYLLA: Yes. You know, at the beginning of the week, I thought I was going to come in and talk about an Establishment figure defeating the populist because …
CONSUELO MACK: You and all of us, most of us.
RICHARD SYLLA: … that’s what the polls told us.
CONSUELO MACK: Right.
RICHARD SYLLA: And then we were all surprised when the populist defeated the Establishment candidate. So I had to think of different examples, and I think my favorite example is 1828 when Andrew Jackson, the angry populist defeated the Establishment. Who could be more Establishment than John Quincy?
CONSUELO MACK: Than John Quincy Adams.
RICHARD SYLLA: His father was President, he had been Secretary of State, interestingly enough, just like Mrs. Clinton, and Jackson defeats him, and then Jackson goes on. I mean, this, you know, I’m a little worried I’m going to watch what Trump does very carefully because Jackson went on to get rid of our central bank, unleash a big inflation in the early 1830s, financial crisis in 1837, another financial crisis in 1839, Jackson’s out of office by then but it’s all part of a bad decade. In 1840, the Bank of the United States fails as a private bank; 1841, 1842, nine U.S. states default on their debts, American credit is bad. So in that case, Jackson, some people consider him to be a strong President. But as an economist, I have to say he did a lot of damage to the U.S. economy.
CONSUELO MACK: Right, so a President can do a lot of damage …
RICHARD SYLLA: That’s right …
CONSUELO MACK: … to an economy.
RICHARD SYLLA: … especially one who is so very self-confident, you know?
CONSUELO MACK: Right.
RICHARD SYLLA: And sort of some of us look at Mr. Trump and say he’s very self- confident.
JASON TRENNERT: Yes.
CONSUELO MACK: We hope that this office can make people more humble. You never know.
JASON TRENNERT: Yes, one would think.
CONSUELO MACK: Yes. So Jason, populism, it is not isolated and unique to the U.S. There are populist movements going on in Europe and elsewhere around the world. So talk to me about how significant that is to economies and markets.
JASON TRENNERT: Well, I think you’ve got some sense of that obviously earlier in the year with Brexit …
CONSUELO MACK: Brexit.
JASON TRENNERT: … clearly. And I also think that what you’re having, I think, is a little bit of a backlash against political and intellectual needs. There are a lot of things that PhDs from both parties have told regular people are good for them. So the Republicans started talking about nation-building and free trade, quote, unquote, and I think the Democrats, we talk about open borders or the Affordable Care Act, or central bank, talking about negative interest rates, all of these things that average people are saying, gee, I’m not so sure this has been so good for me. This is …
CONSUELO MACK: And in fact …
JASON TRENNERT: … you keep telling me this is good for me and I’m just a person without a lot of political sway, and this has actually been harmful. I think that’s playing out. Of course, the biggest experiment is the European Union itself, the biggest example of something that was driven by the elites.
CONSUELO MACK: Of elites?
JASON TRENNERT: Of elites, something that there wasn’t a groundswell of support for, and I think that will probably be put to the test unfortunately in 2017. We have an Italian referendum in a couple of weeks. We have also elections in France and Germany next year, and there are clearer parallels between our populism and the populism you may see in Europe.
CONSUELO MACK: Right. And so, Dick, this questioning of the Establishment and the existing order. We have certainly seen that in this country, but again, are there parallels that are particularly apt that you can think of where we saw this kind of unrest and pushback by votes?
RICHARD SYLLA: Immigration was a big discussion in the current campaign. Well, in the late 19th century, immigrants were really coming into the United States from Eastern and Southern Europe, and even a bit earlier, it was the Irish. And the people already here tended to look down on the immigrants and say bad things about them. And we even cut off Chinese or Asian immigration in the 1880s while we kept having it from Europe. So it’s kind of a consistent theme in American history that the people who are already here don’t, they look down on the immigrants and somehow they’re …
CONSUELO MACK: Right, on strangers, right.
RICHARD SYLLA: … they’re dangerous. But in our current situation, I mean, it seems to me that, you know, I’m an economist and we study, economists tend to be for free trade and what you find out in free trade is that, well, there are winners and there are losers, but what the winners win is greater than what the losers lose. And so, therefore, we should all be for free trade but the winners should sort of do something for the losers. I think what’s happened to us to explain populism here today, maybe even in Europe, is that the winners forgot about doing something for the losers and the losers are sitting there saying, I’m a loser. I’m going to back somebody who says he’s going to straighten this all out.
CONSUELO MACK: And you disagreed with that, I mean, just agreed with that …
RICHARD SYLLA: I do.
CONSUELO MACK: … that that is a sense that you have as well.
RICHARD SYLLA: Yes, I think the TPP, the Trans-Pacific Partnership, to my knowledge is 5000 pages. It’s two-and-a-half million words. As an economist myself, that doesn’t sound very free to me, you know, free …
CONSUELO MACK: Yes.
RICHARD SYLLA: … and something that’s really free trade agreement might be like a page.
CONSUELO MACK: Right. And are all those pages rules and regulations and the way it’s being governed?
RICHARD SYLLA: They’re rules and regulations. And then, they tend to benefit the most politically powerful, the corporations, other institutions that have a lot of sway. And so, I think Professor Sylla was quite right, I think the people that are somewhat dispossessed that don’t have access to the levers of power start to question some of these policies and really wonder how pure, let’s say free trade, most economists are for free trade, almost all economists. But I do think that there are losers.
CONSUELO MACK: So maybe it’s a good thing that there is some pushback. I mean, maybe it’s not a bad thing that we look at agreements that we just assumed are going to be positive and that we actually look at what’s in those thousands of pages.
RICHARD SYLLA: I think you saw that with the Affordable Care Act. I think again, if another …
CONSUELO MACK: Right, right. Remember no one had read it. They just said we’re going to pass it. We’ll read it afterwards, Nancy Pelosi’s famous …
JASON TRENNERT: … right, and of course, all of these things are driven by wonderful intentions. I mean, I don’t think anyone is acting in bad faith. It’s just that again, once you have legislation that’s that large, the original intent can sometimes get lost.
RICHARD SYLLA: The Dodd-Frank Act was like 2000 pages. It’s a big stack of paper.
CONSUELO MACK: And we’re just now feeling the effects of it and we’re going to feel it for, the regulators are at work, so we’re going to feel it for many, many years to come. Jason, what can we expect from the new Administration and what do we know that you’re actually telling clients?
JASON TRENNERT: Well, I think there are two things I think you know with a fair amount of certainty. One is that I do think certainly Mr. Trump is talking infrastructure spending. I think that’s a very good bet, and I think the Lord knows we need it. He’s also talking about a tax cut on repatriated profits. There seems to be some bipartisan support for that, certainly a lot of support among Republicans for that. So I think that’s something else you can look for.
I also think defense spending, there’s been a lot of talk about that actually on both sides of the aisle about rebuilding the military. So those are three, I would say, things that could probably get done relatively quickly where there is some reservoir of support. The more difficult things come in my view when you start really getting into the nitty-gritty of the tax code. And certainly, Mr. Trump wants to cut corporate taxes and personal income taxes, but that might prove to be a little bit more difficult. It’s a very complex system.
CONSUELO MACK: And Dick, I know you’re concerned about the deficit growing under a Trump Presidency. And when I hear about infrastructure spending, which that’s another one of those things everybody said, oh, that’s great, we really need infrastructure spending, well, where is the money going to come from and how quickly, how shovel-ready is the infrastructure spending that anyone talks about?
RICHARD SYLLA: Well, I think that Mr. Trump, remember, he was a real estate guy and …
CONSUELO MACK: Yes.
RICHARD SYLLA: … real estate guys thrive on borrowing money, I think …
CONSUELO MACK: And building…
RICHARD SYLLA: … probably even more than both candidates talked about infrastructure programs. I think Trump had the more ambitious program and he sort of thinks it’s just like building a building. I go to the banks and they lend me the money. Well, now I’m head of the government, the Treasury will just borrow the money I need. And it worries me a little bit because 15 years ago, we actually had budget surpluses and where people are saying maybe we can pay down the national debt.
CONSUELO MACK: Yes.
JASON TRENNERT: But then, George Bush came in, cut taxes, and launched spending programs in Iraq …
CONSUELO MACK: And war.
JASON TRENNERT: … and Afghanistan, right. So we had more spending, lower taxes, and the budget deficits grew and grew and grew. Then we had the financial crisis and they grew even more. Now Mr. Trump, with the national debt being I think slightly larger than the GDP, is coming in and saying, oh, we can do all these good things and I’m going to cut taxes, so we’ll just borrow the money. And I’m going to watch that because my guess is the national debt is going to go up under Mr. Trump because that seems to be his plan.
CONSUELO MACK: And interest rates are at historic lows so that the pain of paying the interest on the national debt is much lower than it would be if interest rates went up. How does a Trump Presidency affect the Federal Reserve and potential interest rate hikes?
JASON TRENNERT: Well, you’re right, about 50 percent of our debt in the United States actually matures in the next three years, and the weighted average cost to our debt is below two percent. So what Professor Sylla is talking about is potentially very painful for the budget because if just the interest rates do go up, interest rates, they will eventually go up, that will consume a greater and greater portion of the budget. And so, that’s something where it puts the Fed in an awkward position as well, it could at some point. I think for now, I’m not particularly worried about it. I think the Fed probably will probably tighten in a dovish way if that’s possible. But if interest rates and inflation start moving up meaningfully, the Fed could be in a very difficult spot.
CONSUELO MACK: Do you see any impact, Dick, on the Fed from a Trump Presidency?
RICHARD SYLLA: Well, I think they’ll be, if he carries out his spending programs and his tax cuts, then he’s going to be borrowing a lot of money and he probably is more tolerant of inflation than the Federal Reserve is. And so, I think the Fed will probably see rising interest rates. And if he borrows money, I mean, we know the national debt is $20 trillion, one percent rise in interest rates raises the deficit by $200 billion.
CONSUELO MACK: Wow.
RICHARD SYLLA: A one percent increase. I think interest rates are probably going to go up. And so, this is going to be a problem. I mean, it’s right where we can finance the infrastructure of spending at low costs now, but when the economy starts growing faster, we get a little bit of inflation, those interest rates are going to go up. In fact, there are already some signs of upward pressure on interest rates.
CONSUELO MACK: So unless we get the much vaunted pickup in growth that the President- Elect Trump talks about, that’s going to be a problem.
RICHARD SYLLA: I believe so.
CONSUELO MACK: Yes. Jason, as far as the other aspect of this election, of course, was that the Republicans held onto the Senate and they held onto the House. But Donald Trump is a very independent candidate.
JASON TRENNERT: Yes.
CONSUELO MACK: So what is possible that you can think about in his agenda that would pass both the Senate and the House? And where do you think he, what are nonstarters?
JASON TRENNERT: Well, I think the spending I think, it’s pretty easy to spend money at these interest rates as Professor Sylla said. So I would kind of count on that. Again, I think the tax cut on repatriated profits would be quite possible, increases in defense spending as we talked about quite possible. I think some of the other talk and chatter about lowering corporate taxes is potentially very difficult. One of my partners talks about the budget as almost a giant game of Jenga.
CONSUELO MACK: What’s Jenga?
JASON TRENNERT: So it’s very difficult, you have to pull out certain building blocks and if you’re not careful, the whole thing …
CONSUELO MACK: Thing collapses.
JASON TRENNERT:…falls, collapses. So yes, and there’s three-and-a-half million words in the U.S. tax code, so it’s again very, very complex. So I think those are the easy things. I think some of the other things that he is talking about, particularly I think as it relates to governance which I’d like to see as far as term limits, all those things, I think that they might prove to be much more difficult for President Trump.
CONSUELO MACK: What about rolling back regulations. Again, with the Republican Senate and House, well, the Senate has a very probably has a very slim majority, but is that possible? Could we see some rolling back of some regulations?
JASON TRENNERT: I certainly hope so as it relates …
CONSUELO MACK: Affordable Care Act was mentioned.
JASON TRENNERT: … certainly as it relates personally and maybe …
CONSUELO MACK: That’s a law.
JASON TRENNERT: … selfishly I would say, I’d like to see some rolling back of regulations particularly on financial institutions because in some ways, I think the regulatory burden that we’ve imposed on banks has largely sterilized the monetary easing that the Fed has provided, which it hasn’t been as effective. It’s been very effective in increasing financial asset prices but hasn’t done a lot I think again for the average person, the forgotten man, if you will. And I think easing financial regulations might help in that regards.
CONSUELO MACK: Dick, are there examples of independent Presidents who did not follow the party line, and if there are, any lessons there?
RICHARD SYLLA: Oh, yes. I think, I mean, a classic example, we had two candidates from New York easier in history. We had Theodore Roosevelt who was a New Yorker, and he was very independent and a lot of the Republican leadership didn’t trust him. Republicans were the business party. Teddy Roosevelt was a trustbuster, and so, he kind of alienated some of his own party by pursuing large corporations, breaking them up. They thought a good Republican President should be pro-business and not sort of break up companies. So he was definitely somebody who bucked the sort of center of his party.
CONSUELO MACK: Right. And the longevity of a President that bucks the Establishment, I’m just wondering, I mean, how long did they last in office?
RICHARD SYLLA: Well, I think he was popular. He wasn’t really a populist but he attracted a lot of sort of maybe middle-of-the-road people, maybe even some Democrats because of his stance. And of course, he became President when President McKinley was assassinated in 1901, but he was very popularly elected then in 1904, and so, basically had two terms in office. Then he tried to won again in 1912 but he lost then, but he had an Independent party. So that shows you what a maverick he was: if his party wouldn’t nominate him for a third term, he started his own party.
CONSUELO MACK: And that certainly could be a possibility for Mr. Trump.
RICHARD SYLLA: Certainly. One would think given the divisiveness of the campaign that he might pursue some easy wins, which is some things that a lot of people could agree on to, in his wins, bind the wounds that were inflicted during the campaign. And that might allow him to be somewhat more ambitious with some of the other things that he’s talking about. I think trade is the one issue where I have to say, and I agree with Professor Sylla, I mean, this is something where I tend to think of Donald Trump as bullish for stocks and bearish for bonds. The one thing that could change my perception in that regard might be more, I guess, turning the thermostat down a little bit on the protectionist sentiments that he has expressed during the campaign. I think it’s okay to be a little bit tougher on trade, but certainly a trade war would be manifestly inflationary, be very bad for bonds, and I think eventually bad for stocks.
CONSUELO MACK: Would you agree with that?
JASON TRENNERT: Yes, and I think Trump is a bit of a maverick like Teddy Roosevelt. And you know there are a lot of people, there are even Republicans in Congress both in the Senate and the House, don’t like these budget deficits. Trump is going to push things that are probably going to increase the budget deficits. So I think we keep our eyes open for a little clash between the White House and the Congress, and both of them being Republican.
CONSUELO MACK: Now, at the end of our WEALTHTRACK, we ask our guests for one investment for a long-term diversified portfolio, but in this case, I’m asking you for an investment kind of based on this election. So what would it be for a portfolio, what would you have us own some of, Jason?
JASON TRENNERT: I like aerospace and defense stocks. There’s power shares aerospace and defense ETF PPA. I think certainly in the United States, we’re going to spend more on defense. I think another part of Mr. Trump’s agenda is to have our allies spend more on their own defense as well, so take no pleasure in saying this but I think defense spending as a growth industry globally. And certainly, I think given some of the challenges that we’re facing internationally, you might see greater defense spending worldwide.
CONSUELO MACK: Dick, what would your one investment be?
RICHARD SYLLA: Well, I am a historian of interest rates and I happen to know that our interest rates seem to trend for very long periods, two, three, maybe even close to four decades. And what I’ve noticed is that from 1946, the end of World War II, to 1981, that’s 35 years, interest rates generally rose a lot and some of us older people remember interest rates were 15, 20 percent in 1981. Then starting in 1982, interest rates came down. It’s 2016 now, that’s almost another 35 years, interest rates have been trending down. Of course, they go up and down, but the trend has been down, and now, they’re about as low as they ever get. I’ve seen what rising interest rates can do to bond values. So like Jason says, I’m very wary of bond investments now. Portfolio people will say, well, you should have 60 percent stocks and 40 percent bonds, or 50-50 depending on your age. I’m saying right now I’m really worried about that bond component of the portfolio, and I almost think a better investment might be to hold cash.
CONSUELO MACK: Interesting. All right, thank you both so much for being with us on WEALTHTRACK, Jason Trennert from Strategas and Richard Sylla, author of a new book about Alexander Hamilton.
RICHARD SYLLA: Thank you.
JASON TRENNERT: Thank you.
At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is: Stay the course with your financial plan. No matter how you feel about the election results, whether positive or negative, the fact is America’s economy and capital markets are strong, diverse and resilient. Good businesses will continue to do what’s best for their stockholders, employees and communities. Our founding fathers were beyond wise in having three branches of government to provide checks and balances on each other. If you were comfortable with your financial plans before the election you will be confident in them again as Americans get back to business.
Next week, award winning portfolio manager Bill Priest explains how he chooses companies that are capital allocation champions for his MainStay Epoch Global Equity Yield Fund.
To see this program again and hear more insights from Dick Sylla and Jason Trennert please go to our website on wealthtrack.com. Also feel free to reach out to us on Facebook and Twitter.
Thank you for watching. Have a great weekend and make the week ahead a profitable and a productive one.
CONSUELO MACK: This week on WEALTHTRACK: How technology is revolutionizing the economy, business and investing. Epoch Investment Partners’ Bill Priest explains why tech is the new macro, next on Consuelo Mack WEALTHTRACK.
Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack.
There is no question that it’s become harder to be a successful active portfolio manager. As we have covered in previous WEALTHTRACK episodes, 83% of actively managed mutual funds have underperformed their chosen benchmark indexes over the past decade.
Financial thought leader and frequent WEALTHTRACK guest Charles Ellis spent several decades analyzing money managers at Greenwich Associates, the investment consulting firm he founded and ran for years. After much research, debate and angst he has reached the conclusion that indexing is the best approach for the vast majority of investors, including himself.
Here’s what he said in his investment classic: Winning The Loser’s Game.
“Investment management, as traditionally practiced, is based on a single core belief: Investors can beat the market, and superior managers will beat the market. That optimistic expectation was reasonable 50 years ago, but not today. Times have changed the markets so much in so many major ways that the premise has proven unrealistic.”
What’s changed? The sheer volume, talent and resources of global market players have exploded. As Ellis points out institutional investors account for 98% of all exchange trades and an even higher percentage of off-board and derivatives trades. Since they are the market, they can’t beat themselves, especially when they have to overcome the drag of their costs of doing business.
Another major change in investing is technology. The power of computing and data mining is staggering. In many firms investing is largely computer driven. This week’s guest is combining his traditional analytical approach with technology and he is doing so successfully.
He is William Priest, CEO, Co-Chief Investment Officer and Portfolio Manager of Global Equity Investment Strategies at Epoch Investment Partners, which he co-founded in 2004.
Epoch was named Institutional Investor’s 2012 global equity manager of the year.
Among the funds he co-manages is the MainStay Epoch Global Equity Yield Fund which has beaten its market benchmark and Morningstar World Stock category since its 2005 inception with less risk.
MainStay is a sponsor of WEALTHTRACK but he is here based on his performance and approach. Priest is the author of several books on investing including Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor which details Epoch’s investment discipline. His latest book, co-authored with two Epoch partners is Winning at Active Management: The Essential Roles of Culture, Philosophy and Technology.
I began the interview by asking Priest why he calls technology the new macro.
BILL PRIEST: If one looks at technology one needs to kind of understand why now, why is someone calling it the new macro today? And it all starts with Moore’s Law. Gordon Moore was the founder of Intel and he came up with this idea that he thought the power of the computer chip per dollar would double about every 18 to 24 months. Well, he said that in the mid-‘60s so we’ve had 30 some years where this doubling has gone on. And when you’re doubling something at that rate at some point it reaches critical mass and explodes. Now, the best example that I can give you is a myth and it was mentioned by Ray Kurzweil, who was a futurist. And he tells a story about an emperor in India who asked his subjects for a new game. And one subject came up with the idea of chess. And he was so excited about it, he said, “This is the greatest game I’ve ever seen. How do I reward you, the inventor?” The gentleman said, “Well, why don’t we just use the chessboard to count. I really just want some rice to feed my family. So we’ll put one grain of rice on square one, two on two, four on three, doubling of every square.” Well, after 32 squares of this 64 squared chessboard you have about four billion grains of rice, and as you keep doubling it turns out you have a sum that’s equal to really all the rice that was ever produced in the world at that time. Now, what the point of that story is, and is brought forth in Brynjolfsson and McAfee’s book, The Second Machine Age, is to demonstrate the fact that technology is about to enter the back half of the chessboard. What we’ve seen is one thing, what we’re about to see is something else and it’s growing at an exponential rate.
CONSUELO MACK: You think it has profound effects on the economy and in business, and we’ll get to the investment effects in a minute.
BILL PRIEST: Okay, well, if you’re doubling at that rate at some point, and Brynjolfsson points this out, as this chip power is doubling.
CONSUELO MACK: Right.
BILL PRIEST: You get to the point where you literally can digitize everything. Everything we can think of, music, everything has been digitized and it occupies a place in the cloud. And all that data in the cloud is now, through a myriad of algorithms, you can recombine that data in a number of ways. So how it impacts the real economy is effectively by substituting technology for labor and substituting it for capital. So there’s something in finance called the DuPont Return on Equity Formula. Essentially, it’s the assembly of three variables. Profit divided by sales is considered profit margins. Sales divided by assets is asset turnover. If you multiply one of those components by the other you have what’s called return on assets. Now, if ROA is going up you really do not need the same amount of capital in the business itself, which means that dividend payout ratios can go much higher than people think. You can basically take money out of the corporation because it won’t be needed. If you add one other variable, which is assets per dollar of stockholders equity, that indicates the leverage that’s in the business. Technology impacts every one of those three components, so if you assume for a moment that revenues are the same, if you can substitute technology for labor, your labor costs go down and profit margins go higher. You can also argue and demonstrate that you don’t need the same amount of physical plant today to generate a dollar of revenues.
CONSUELO MACK: So that’s great for businesses if you’re a consumption-oriented economy like the United States that has a dark side to it, a downside.
BILL PRIEST: It has a potential dark side and the way to think about it is another story. And once upon a time, Henry Ford was supposedly dealing with Walter Reuther of the United Auto Workers and they were negotiating a wage agreement. And Ford said, “Listen, Walter, I can get machines to do the work of your laborers.” And Walter came back and said, “Yeah, but will machines buy your cars?” So the key here is robots and artificial intelligence, they don’t buy anything.
CONSUELO MACK: Right.
BILL PRIEST: So if you’re substituting a machine for, let’s say, a hundred people, what does that say about consumption? And the argument, other things equal, would be consumption just can’t be at the same level it was before. Now, productivity may go up, but consumption won’t be the same as it was before.
CONSUELO MACK: It sounds like because of technology and other factors, but this technology being the new macro.
BILL PRIEST: Right.
CONSUELO MACK: That companies are going to be, well run companies are going to be much more profitable, therefore this is a good, it’s a good investment …
BILL PRIEST: Absolutely.
CONSUELO MACK: …environment.
BILL PRIEST: Absolutely. It will be, other things equal it will be a good investment.
CONSUELO MACK: Let’s talk about one of the hallmark of Epoch’s investment approach, and it is that, you’ve always told me that the first question you ask a company when you go to visit it is, “How are you allocating your capital?”
BILL PRIEST: Right.
CONSUELO MACK: And tell us why that’s more important than, the decisions of how they spend their free cash flow is more important than their earnings, growth of their revenue, or the size of the company? Why is that so critical?
BILL PRIEST: Well, if you go back in time, go all the way back to the ‘60s when there was a Nobel Prize in Finance awarded to Franco Modigliani and Miller, what they demonstrated in their paper was the value of a company is the function of its cash flow. That fundamental insight is core to everything that we at Epoch do. So when you look at what free cash flow itself means, free cash flow is the cash available for distribution to shareholders after all planned capital expenditures and all cash taxes. When we talk to a CFO they generally agree with that definition. They may tweak it a little bit, but they generally get there. Then the key is, “So how do you guys allocate among five choices? Pay a dividend, buy back stock, pay down debt, make an acquisition, or reinvest in the business?” Those are the five choices that every company has. So what you want to hear is how they go about doing that.
CONSUELO MACK: Right.
BILL PRIEST: Now you have to go about your due diligence in looking how they’ve allocated in the past. But companies that are good capital allocators, they will win. They will win in the long run. There can be a regime like we’ve just had where they may not win and I’ll give you an example. If you were to look at the MSCI, the Morgan Stanley Capital International Index which is a big global index, over the last 57 months that index is up 79 percent. It’s a stunning number over almost five years. Of those 79 percentage points 68 were due completely to PE multiple expansion.
CONSUELO MACK: Nothing to do with capital allocation.
BILL PRIEST: Nothing to do with earnings.
CONSUELO MACK: It’s just how the market is responding?
BILL PRIEST: Exactly.
CONSUELO MACK: Okay.
BILL PRIEST: It was a constant decline in real interest rates that drove up the value of the cash flows that were present. But it’s also amazing, in the MSCI over 57 months the earnings gains were actually a negative number.
CONSUELO MACK: Yes, right.
BILL PRIEST: Amazing to me.
CONSUELO MACK: Let me ask another question about technology. So why if technology is enhancing, you know, companies’ profitability, which you and I just talked about, why have we seen this, you know, this decline in earnings over the last five years?
BILL PRIEST: Well, part of it is probably due to accounting and some of it is due to what happened to the oil industry and the material industry, I’m sure.
CONSUELO MACK: All right. So that affected the number.
BILL PRIEST: So if we excluded that you probably had a positive number. But the truth is the world had very low growth. And in the long run earnings growth tends to map over to growth and nominal GDP. Real GDP being growth in the workforce plus productivity. If we add one other variable, inflation, we come up with nominal GDP. The sum of those three numbers is nominal GDP and in the long run nominal GDP historically has been a very good proxy for earnings growth. Whatever you think nominal GDP is going to be, in the long run that’s a pretty good proxy for earnings. The reason now why earnings may grow faster is because of technology and it won’t necessarily be a lot, but it should be as good or possibly more because of the role of technology.
CONSUELO MACK: So Bill, I understand you have a project at Epoch that you call Racing with the Machine. You are using technology. Tell us about that?
BILL PRIEST: You can see today that there is, no one can beat IBM’s computer, at chess, and was able to beat every human being at the game of Jeopardy. However, there’s something called Free Chess, and Free Chess is where an individual plays a computer and has a computer program by his side. So if the machine is by your side you can beat, you can beat the computer.
CONSUELO MACK: Oh, interesting.
BILL PRIEST: In many things. So taking that as a principle, the only reason to have portfolio managers or analysts is because you think they have judgement. You want to leverage that judgement so you want them racing with the machine. So what does that mean? Well, the machine is about data. What data do you think is needed and necessary for your investment process. If you can provide that data to analyst in a form that he likes and in a way that allows him to look at many names you should be able to improve his batting average or at least he will have more at bats. If you think of the book Moneyball, it’s sort of the same thing. You’re taking statistics, and the GM, and Theo Epstein who just won everything for the Cubs.
CONSUELO MACK: Won for the Cubs.
BILL PRIEST: He’s probably maybe the greatest General Manager in the history of baseball, but he is able to take data in a form that’s useful to him and improve his judgments. We want to do the same thing in the investing world. And I think any investment firm that doesn’t incorporate technology into what they do, my guess is they will have a situation ten years out where they will not be competitive.
CONSUELO MACK: Do you have any evidence that it’s made your investment results better by using the technology as … ?
BILL PRIEST: What we’ve done is we’ve developed something called the Epic Core Model. So much of this is proprietary, but over a period of a dozen years the Epic Core Model essentially has been successful at creating a broad-based, unanalyzed portfolio that has generally beaten the market. It essentially is able to take the market and say, “These are names you should ignore and these are names that you should look at.” So think of creating two pools. Fish here, don’t fish there. If it can really do that and it can continue the history it has, just think of how you can direct your analyst to spend all your time fishing here. Now, maybe, maybe the answer is 55-45, but if you know, if you have a pool of opportunities, and if you can fish here and 55 percent should have a positive outcome somewhere in there and others are 45, there are some winners over here in the 45 percent pool. But it’s not worth spending your time. These we call errors of omission. We can live with those. Over here, this is a better place to fish and we want, the errors we make, we will make plenty of errors, we just do, but with their errors of co-mission. But at least when we make them the chances of winning are higher in this pool than in this pool over here.
CONSUELO MACK: And you’ve got much more data to work with than you could possibly have even with, you know, a slew of analysts, right? Because they can, the computers are crunching the data for you.
BILL PRIEST: An example would be.
CONSUELO MACK: Yes.
BILL PRIEST: This goes back many years because I’m not the youngest guy you’ve ever interviewed. When I was an analyst the first time I took a project of looking at data in the railroad industry. I created what at the time was a regression program to look at final demand and I looked at a number of variables. It took me six to eight weeks to do this. It was a lengthy project. And this was before PCs. This was on an electromechanical calculator. Today, you can do exactly what I did in less than 45 minutes.
CONSUELO MACK: Wow.
BILL PRIEST: You pull the data out of the cloud, you build your algorithm, and voila, there are results. You may not like them, you may like them or not like them, but then you can say, “Okay, that didn’t work,” and we try another set. It’s this ability to recombine data in an incredibly fast way that allows you to race with the machine.
CONSUELO MACK: And you told me that Epoch’s approach, looking at the capital allocation decisions that companies make.
BILL PRIEST: Right.
CONSUELO MACK: Give us a couple of example of current holdings in your portfolios of companies that are good capital allocators. And when you were on with me in 2010, for instance, you mentioned Microsoft. Is that still doing the job for you?
BILL PRIEST: It is. The composition of Microsoft has changed and the leadership has changed, but Microsoft pretty much fits the bill today. Microsoft is generating hefty free cash flow. They’re one of the leaders probably after Amazon, the number two leader in the cloud. It’s growing rapidly. It’s very profitable. They’re very good capital allocators of late. They have been poor in the past. They made some acquisitions that turned out to be pretty much worthless. But an example of the incentive to invest, and when you look at this world today of reinvesting, the key is can you reinvest at a rate above your cost of capital we talked about earlier. Well, they just bought LinkedIn. They paid $26 billion for LinkedIn. LinkedIn is modestly profitable. You might say, well, why, why would they do that? Well, look at how they paid for it? They used cash and debt. Their incremental cost to capital was probably not much more than 150 or 200 basis points.
CONSUELO MACK: So 1.5 percent to two and a half percent.
BILL PRIEST: Right.
CONSUELO MACK: Right.
BILL PRIEST: Something like that. All they have to do is earn four or five percent on that investment and it accretive to the value of the company. There has been an incredible incentive to speculate with low rates where they are. That’s one of the reasons you’ve seen this huge amount of M&A. It’s likely to continue this large as long as rates are low. Now, once the cost of capital starts to rise maybe you’ll see a little less of that. But it certainly hasn’t risen today to a point where I would expect much of a slowdown. But under the new, a new leadership I think their capital allocation policies have improved and the stock’s done quite well. Particularly since the last time I mentioned it.
CONSUELO MACK: Yes, and another example that you’ve mentioned to me before we were doing the interview was Google. It’s a newer name.
BILL PRIEST: Yes.
CONSUELO MACK: Why is Google a good capital allocator?
BILL PRIEST: Well, Google has been a great stock for a long time and we did not own it because we couldn’t really understand their capital allocation process. I think what prompted us to buy it was the addition of Ruth Porat as their CFO.
CONSUELO MACK: Their new CFO.
BILL PRIEST: And they are a money machine when it comes to their search engine and YouTube. But there’s all kinds of other stuff they do where it’s kind of hazy where the money goes. Is there any discipline to spending it and what not. And Ruth has clearly brought some discipline there. So today you have a company that’s selling at, oh, we think something on the order of maybe a 17 percent, has a 17 percent growth rate and maybe a six or seven percent cash flow yield at this point, in terms of its free cash flow yield, and we think that’s attractive.
CONSUELO MACK: A couple of more questions.
BILL PRIEST: Sure.
CONSUELO MACK: One is you’ve got a new book. It’s titled Winning at Active Management. And you certainly as an active manager of some of your funds, they’ve won all sorts of awards, you’ve beaten your benchmarks, so you’re succeeding as an active manager. The vast majority of your competitors are not. Why is it so difficult to beat the indexes?
BILL PRIEST: Well, part of it is what kind of world are we in? And there’s two things going on. We talked a little earlier about the last five years where the MSCI is up 79 percentage points and 68 is multiple expansion. If that’s the regime you’re in, if that’s the period of time, it is almost impossible for active managers to win. An index fund will win a lot of the time because it has nothing to do with dividend analysis or earnings. It’s just the capitalization rate went up. And also remember that most active manager hold a little bit of cash. Maybe it’s only three percent. That doesn’t sound like much, but in a market that’s up 80 percent and you have a three percent cash position you have a drag of 240 basis points per year. So you are behind on Day One. Now, there’s always somebody who’s in the first quartile. So how about those guys that did well even in that regime? Well, you have to analyze them very closely. Are they like a stopped clock? Did they get well because this is how they built it and it just happened to be, allowed them to become or did they actually foresee a market where multiples were going to expand, earnings were going to be stagnant, and dividends were going to matter a little bit? I would argue very few people saw that. Now, once you get to the period where PEs are going to be zero on average the opportunity for active management is quite high. And in the book we emphasize three things. I don’t think you can win without a culture that focuses on the client winning. And at the heart of that is a fundamental difference between the asset owner and the asset manager. The asset owner, for the most part, is for the benefit of the members entity. In other words, he is working for a group or an institution that’s all about bettering the members. Asset managers are for profit. You want to get that gap as small as possible. You don’t want to create a case where the manager can win no matter what and the clients lose.
CONSUELO MACK: Right, okay.
BILL PRIEST: And you will never get them aligned perfectly, but you want a culture where you actually talk about the clients winning. You’d be surprised how many institutions, that’s the last thing they talk about. But at Epoch the client needs to win or we don’t deserve to win.
CONSUELO MACK: And the other thing was, it’s culture, philosophy, and technology. We talked about technology, but the philosophy.
BILL PRIEST: The philosophy is really all about free cash flow. Free cash flow drives value and the allocation of it will allow you to ascertain the winners. We’re not perfect, we have our, we have plenty of mistakes in our past, but if you can line up the culture, the philosophy, and embrace technology as an aid to decision making. Judgement is the scarcest resource of all in any area. You’ll pay the most for it. We don’t want to substitute quantitative finance, for example, with fundamentals. We want them to work alongside one another. In the end, I want that analyst, if he makes six to eight picks a year, I’d like to make him have 12 to 14 picks a year. If he can bat 55 percent, that’s all he has to bat, the clients will be happy and we’ll have a wonderful business.
CONSUELO MACK: Final question. One investment for a long term diversified portfolio. What should we all own some of in my son’s 401(k), for instance.
BILL PRIEST: Those questions are always dangerous, but if I had to pick one I’d probably pick Google.
CONSUELO MACK: And the reason being …?
BILL PRIEST: The reason being it’s an incredibly creative institution. They have two huge cash flow engines in YouTube and the search ability and now they’ve got some disciplined capital allocation, and I think they will have big market shares, lots of cash flow, and I think their future’s very bright.
CONSUELO MACK: Bill Priest, thank you so much for joining us on WEALTHTRACK again.
BILL PRIEST: Thank you.
CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: read The Second Machine Age: Work, Progress and Prosperity in a Time of Brilliant Technologies by Erik Brynjoflsson and Andrew McAfee.
You might remember the stir these two MIT economists caused in 2011 when they self- published a short, 60 page ebook, “Race Against The Machine” which analyzed the role technology was playing in the anemic job growth coming out of the financial crisis.
The Second Machine Age, which recently came out in paperback goes far beyond that and explains why in the words of one reviewer we are “…on the cusp of a dramatic growth spurt driven by smart machines that finally take full advantage of advances in computer processing, artificial intelligence, networked communication and the digitization of just about everything.”
Knowledge is power. Understanding the revolutionary role technology is playing and will play in our lives is a must for our personal development and that of our country.
Speaking of which, next week during fund raising season on public television we will revisit our show on the election, historical parallels and lessons plus market and economic impact with historian Richard Sylla and strategist Jason Trennert.
To see this program again and other WEALTHTRACK interviews please go to our website wealthtrack.com. Also feel free to reach out to us on Facebook and Twitter.
Thanks for watching. We have so much to be thankful for and make the week ahead a profitable and a productive one.
A rare interview with Artisan International Fund’s Mark Yockey. Where is this award winning portfolio manager finding growth in a low growth world?