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.
