Welcome 


Shortly after I graduated from college, I had the good fortune of being able to stay with a good friend in Chicago while I looked for a job and started career.  Coming from Iowa, the idea of living in the big city of Chicago was a daunting, but exciting prospect.  I ended up having an extremely positive experience — largely due to the gracious efforts of my friend to serve as a “tour guide”.  He went out of his way to show me the ropes of living in the landscape of a major metropolitan area.

When I hear people discuss their challenges with investing, I see many parallels with my experience in moving to Chicago.  There is usually a lot of action and a lot of noise and it can be overwhelming.  It’s easy to get distracted and to make mistakes.  I think what many investors could really use is a good tour guide to help them navigate the investment landscape. 

A good, native, guide can make a lot of things easier.  For example, a guide can show you the bad areas of town to avoid.  This is extremely helpful because seedy or dangerous areas don’t always look that way on a map or a guidebook.  In the same vein, a guide can also sidestep the tourist traps.  Plus, things change and a guide cap keep you apprised.

In addition, a good tour guide can help distinguish real threats from perceived ones.  For those people who don’t spend a lot of time in large, urban environments, there are a lot of people and behaviors that will seem strange and unsettling.  This is unfortunate because it prevents a lot of people from enjoying the many charms of the city as much as they could.  A native can quickly distinguish between normal city behaviors and real threats. 

On the positive side, a good tour guide can navigate ably and efficiently through the city to really showcase a city’s unique charms and to allow one to get the most out of the experience.  By going to the iconic attractions at the right times, big crowds and long wait lines can be avoided.  A good tour guide knows lots of little tidbits of history and landmarks that won’t show up on maps or in books.  And finally, a good tour guide can show you where the locals go to eat, drink, and socialize — all of which capture the unique flavor of the city.

Most investors do not “live” in the capital markets so investing really is a lot like being in a new city.  There is a wide array of options for taking in the experience, and the best option for any particular person depends on what he or she wants to get out of it. 

Investing with index funds, for example, is a very passive experience, like riding a bus on an expressway through the city.  Sure, you get “exposed” to the city, but you miss out on a lot too.  Buying a mutual fund might be more like a hop-on, hop-off bus tour of a city.  These tours can give you a nice general impression of what a city is like, but are still fairly superficial. 

In addition, visitors can always organize their own trip.  This arrangement allows for greater flexibility, but also requires much greater effort and is fraught with risks.  Almost everything is harder than it needs to be and it is all too easy to get lost while figuring out directions and paying attention to strange traffic patterns.  It is also all too easy to end up somewhere you don’t want to be, and to miss what you do want to see.

For those who are investing over a long time horizon (e.g., for retirement) and who want to learn and take things in along the way, there are surprisingly few good options.  Many providers are accessible, but lack intimate knowledge of the terrain.  Other providers have strong local knowledge, but distribute it only indirectly through “products”.  Very few bring the knowledge and expertise of reading piles and piles of 10ks and proxy statements and listening to conference calls and analyzing financial statements and other models — AND — can translate that expertise into insights and answers to help YOU.

When I moved to Chicago, I did take in all the major attractions, but I learned a lot more than just that.  I also learned several safety lessons which gave me confidence to be in the city.  I learned the rhythms of the city and how to get around.  And I embraced all of the great neighborhoods and cultures and architecture that make cities like Chicago so dynamic.  I enjoyed the experience so much that after having never spent more than a few hours in a major city, I have lived in one ever since.

Now, with Arete, I am trying to provide the same type of experience for investors.  I want Arete to provide the type of experience that is far more than just a neat visit and more like the one I had in moving to Chicago.  I want Arete’s investors to use me as a resource, to learn more about investing, and to learn about the great attractions in the mid cap universe.  Hopefully, some will even develop the same lifelong appreciation I have.  If you, or someone you know, ever has an interest, I would love to be able to show you around the landscape of mid cap stocks!

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights 

Warren Buffett once said, “There is so much that’s false and nutty in modern investing practice and modern investment banking . . . If you just reduced the nonsense, that’s a goal you should reasonably hope for.”  Many investors intuit such nonsense; they feel they are not being well-served but are either resigned to the fact, don’t know who is responsible, or don’t know what to do.  Where does the nonsense come from? 

The short answers are growth and complexity.  As the industry has grown and specialized, many behaviors and incentives have evolved which can subvert the goal of serving the best interest of investors.  This is not to say that there is a lot of malicious intent; that is not the case.  It is to say that industry and organizational structure are often more important than the intent of individual professionals in determining the value investors receive.  We provide the following commentary as a brief guide of some potential problems to beware of in protecting your interests.

The investment process starts for many investors with a plan to diversify assets by allocating to various asset classes.  For institutions this often done by a consultant; for individuals it is often done by a financial planner.  From a very high level, the allocation exercise makes perfect sense since diversification can lower portfolio risk without any cost to return.  

The challenges normally come with implementation.  Too often, asset allocations represent a very narrow responsibility in the form of merely establishing exposure to asset classes.  This exercise can fall short of fulfilling client investment needs in many ways. 

First, during times of extremely high cross-correlations among assets, such as the one we are in now, asset allocation provides very little diversifying benefit.  When this happens, it is critical to redouble and re-evaluate efforts to improve diversification and to communicate the diminished value of the exercise to clients.  If this is not done, clients may be taking on much greater risk than they realize.

Second, entire asset classes can be overvalued or undervalued for significant periods of time.  Without significant valuation expertise, historical perspective, and strong analysis, it is quite possible for the allocation exercise to fail a very simple criterion: to generate returns commensurate with risk for investors. 

Third, many times asset allocation schemes are implemented with index funds and ETFs (exchange traded funds).  While these vehicles can provide cheap access to a wide variety of assets, there are risks to be aware of.  Most importantly, many indexes are weighted by market capitalizations.  In these cases, overvalued assets get overweighted and undervalued ones get underweighted.  Strange but true, these indexes systematically favor the least attractive investments.  As long as new money pours into the same investment vehicles or asset types, their performance looks great.  Once it leaves, look out: think NASDAQ 2000-2002.

Finally, the asset allocation exercise represents valuable real estate in the chain of communication with clients.  Most clients prefer to work with one vendor and the asset allocator is in the best position to be the single contact.  That position gives the allocator the ability to act as gatekeeper for all of the other managers.  Many allocators take advantage of this role by emphasizing in-house, proprietary funds, by charging a toll on other providers for the privilege of gaining access to their clients, or by excluding access to a wide swath of managers altogether.  Each activity happens at the expense of making the very best funds available to investors. 

Investment managers, as a group, are no less guilty of perpetrating their own nonsense.  Many managers, acutely aware that many clients, including asset allocators, are watching over their shoulder every day, become slavishly beholden to relative performance.  As a result, many managers are more interested in guessing what other people are going to be buying tomorrow, rather than doing the real work of figuring out what an investment is worth today.  Effectively, managers subject themselves to a “game” of running short sprints when their ultimate investors want them to compete in the marathon.  
This behavior is exacerbated by the fact the many performance bonuses are paid on an annual and even a quarterly basis.  These periods are ridiculously short for most investors.  Further, because so many analysts and portfolio managers are so far removed from their clients, often never meeting them, the idea of serving a client is an abstraction that does not motivate them. 

It may seem odd to claim that for all of the knowledge and expertise in the investment management industry, the job of ensuring that clients end up with investments that leave them better off too often falls through the cracks.  Yet it was our own encounters with such nonsense that led to the creation of Arete.  Indeed, we continue to hear from other analysts and portfolio managers who corroborate our experiences that misspent resources and perverse incentives often prevent investors from deriving as much benefit from the process as they should.  While many larger firms do have “superior access to resources”, too often those resources fail to generate incremental benefit for investors.

Arete was formed with the intent of providing an accessible alternative to much of the nonsense.  In particular, we focus on creating a portfolio of investments and communicating our insights so as to improve the welfare of our clients.  We believe this is a simple proposition most investors want, need, deserve — and too often cannot find elsewhere.

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  “Lessons from the Trenches” highlights our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

One of the many great aspects of investing in mid cap stocks is that there are so many interesting and growing businesses to learn about.  In fact, we regularly run a screen of all US stocks with market caps between $1B and $20B (which produces about 1,500 companies) and we regularly review Value Line statements in order to stay apprised of the landscape. 

In a recent review of Value Line, we looked through the food processing industry for ideas.  In particular, we were wondering if we could find stable, defensive, dividend-paying companies that were still cheap.  One company, Sensient Technologies (ticker SXT), stood out for the stability of its cash flows over time so we proceeded to qualify this idea with our valuation work.

We normally employ our valuation tools fairly early in the research process for a couple of reasons.  First, the exercise gives us an idea as to whether valuation appears so compelling as to warrant accelerating the process, or whether it can be relegated to the “bullpen” and investigated more thoroughly later.  Second, our valuation analysis allows us to identify the strategic priorities of companies very clearly — which has profound implications for where and how the company’s management should be trying to create value.  This, in turn, allows us to prioritize research objectives quickly and efficiently.

By way of background, we license the valuation model from Applied Finance Group (AFG).  This particular model is essentially a very sophisticated discounted cash flow model.  The great advantage of the model is that it makes a wide array of adjustments to reported accounting numbers such as earnings and capital so as to better reflect economic reality.  The model has consistently outperformed competing approaches in accurately representing value over time.

As we often do, we started the valuation exercise by running current consensus estimates through the model.  In addition, we reviewed several other financial numbers and relationships and made adjustments so as to most accurately reflect the performance of the business.

The result can be seen in the screenshot below.  We found a very strong relationship between the warranted value of SXT (based on discounted cash flows and indicated by the dotted blue line) and its historical stock performance (indicated by the hi-lo-close bars).  This result is testament to both the regularity of SXT’s financial performance and to the incredibly powerful ability of the AFG model to capture economic reality.

The feature that really stood out to us was the divergence in the trajectories of warranted value and market prices beginning in 2010.  Normally when peculiarities like this arise they signify the need for further modifications to properly represent the business.  In this case, we thoroughly reviewed our work and couldn’t find any opportunities to improve the quality of the inputs.

Why did SXT prices maintain such a tight relationship with warranted values for so many years and then break that relationship in 2010?  One of the rewarding aspects of using a great model is that it allows the testing of a variety of “what if” scenarios.     

In this case, we decided to test a hypothesis.  When Bernanke first discussed quantitative easing in August 2010, the promise of low interest rates created a real challenge for savers and investors which induced incremental demand for safe, stable, dividend-paying stocks.  What if that incremental liquidity did not help the entire market, but rather only a certain subset of stocks?  We tested our hypothesis by reducing the cost of capital for SXT by 200 basis points beginning in 2010.  The result is shown on the next page.

The model fits the price action with remarkable accuracy.  While this is only anecdotal evidence, it provides some incredibly useful insight to market conditions.  The SXT model suggests that the stock’s price is artificially inflated due to monetary intervention.  Insofar as this is the case, the implication is that SXT stock price is at risk as soon as monetary policy changes or investors have reason to refocus on investments with better long-term return potential. 

We aren’t good at figuring out when trends begin and are even worse at guessing when they will end.  What we are very good at doing, however, is figuring out what stocks are worth and buying them when they look exceptionally cheap.  We will miss fads and busts, but we invest our clients’ money in assets that make sense and with a long-term horizon.  Rigorously applying the AFG valuation model is one of many tools we use to accomplish that goal.

Welcome

“Greece Schmeece” I can almost hear people say as they roll their eyes.  “What does it matter to us?”  

I certainly empathize with this view.  Sometimes the news coming out of Europe seems like a soap opera that never ends.  While it can certainly be tiresome and tempting to dismiss, it really is important for us to watch.

The reason Europe matters so much (and Asia too, but let’s stay on one topic at a time) is because so many parts of its financial system and economy are interconnected with those in the US.  Just like a group of mountain climbers that are tied together by a rope, if one climber falls, the adjoining climbers will certainly feel the pressure of the additional weight. 

In normal conditions, this may be just fine.  The fallen climber can be supported temporarily by his fellow climbers until he regains his hold.  In adverse conditions, however, the fellow climbers may not be able to maintain support.  They also may eventually succumb to the additional weight and lose their grip.  When they fall, it can precipitate a cascade whereby everyone falls.

The technical term for this type of situation is “tight coupling.”  When components have close causal relationships and propogate shocks very quickly to other components, a system is tightly coupled.  The mountain climbers are tied together so as soon as one falls, the adjacent climbers feel the effect immediately.  There are a lot of other examples of tight coupling such as just-in-time (JIT) manufacturing, and the global financial system. 

In very broad terms then, Greece is the fallen climber.  They will not be able to repay all of their government debt.  Since many banks across Europe hold Greek debt, they will need to write it down.  Since many of these banks are undercapitalized, they will need to find a way to raise capital in a very difficult environment.  In many cases this will likely lead to reduced lending.  Since banks provide a much larger share of funding in Europe than in the US, this is likely to create a significant impediment to growth there.  Lower growth will mean yet more bad loans for banks to absorb.  US companies that do business in Europe or that borrow from European banks will be affected.  In short, this all matters to US markets.   

It shouldn’t be any surprise that tight coupling is a situation to be managed very carefully.  Rick Bookstaber, author of Demons of our own Design, goes so far as to attribute one of the primary causes of the 2008 financial crisis to tight coupling.  Tight coupling contributed because there were close causal relationships between many components of the financial system.  This was exacerbated by complexity because the vast array of interconnections were too numerous and diverse to manage or control.

An extremely important step in any risk management effort is recognizing when you are dealing with a complex, tightly coupled system.  When these conditions exist, which they unfortunately still do, the system remains especially vulnerable to significant disruption.  In other words, things have the potential to get bad quickly.

Bookstaber describes a common mistake, “It might be reasonable to consider crises as hundred year flood events if we mistakenly treated them as being drawn from the same distribution as those normal market days.  But they are not.”  In other words, it is appropriate to treat crises as conditional probabilities.  They don’t happen that often, but they are far more likely when certain, identifiable conditions exist. 

Another important step in risk management is simply to avoid areas of heightened risk.  An important aspect of avoidance is nothing more than having the will to do so.    In his blog article, “Common Sense Crisis Risk Management,” Bookstaber acknowledges the challenge for managers: “It is not hard to take steps to protect against a crisis . . . [but] it is exactly the opposite of what makes money as the market is building into a crisis.”

One of the things that drives me crazy is when I hear investment advisors who are dismissive of risk.  I don’t particularly care if they don’t know, don’t see it, are not even bothering to look, or see it but lie about it.  The end result is that investors can get hurt.  I don’t expect anyone to be perfect, but I do expect them to try to provide a clear assessment of the investment landscape.

Anyone who knows me knows that I don’t have any aversion to adverse conditions.  I am perfectly happy to gear up and walk through rain, wind, snow, whatever.  I have even been accused of enjoying it.  Where I draw the line though is when conditions present a real danger to safety.  Whether it is a lightning storm in the Grand Tetons or a white-out in a snow-bound pass in Glacier National Park, when I see dangerous conditions, I turn around. 

I take the same approach to managing risk in the Arete Mid Cap Core strategy.  I spend a lot of time to scan the investment environment and to identify relevant risks.  Arete is very well positioned to provide “weather forecasts” and to communicate closely with investors in ways that they are extremely unlikely to find at larger competitors.  If you have questions or would like to follow up with anything I address, please always feel free to call or email. 

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights

The world of investing is largely a segregated one with the big institutional investors generally having access to better managers and lower fees than individual investors do.  Individual investors have the same wants and needs from their investment services, but generally do not have the same resources to verify the quality of their services providers.  Instead, individuals often resign themselves to selecting among whichever services are sold to them. 

One of the most important characteristics that many large, well-managed institutional funds look for in money managers is a focus on “best ideas”.  Large funds want the benefit of the pure expertise of their managers.  When they hire active managers, they don’t want to pay up for a number of holdings that can be acquired cheaply through index funds.

A study from researchers Martijn Cremers and Antti Petajisto of the Yale School of Management corroborates the efficacy of this approach.  After reviewing the performance of over two thousand mutual funds over a twenty-three year period, they found that a measure called Active Share was useful in predicting fund performance. 

Active Share is defined as the “percentage of stock holdings in a manager’s portfolio that differ from the benchmark index” (Investopedia).  The study concluded that funds with Active Share of 80% or higher beat their benchmark indexes by about 1.5% after fees.

In an important sense, this shouldn’t be surprising.  After all, how can a fund significantly outperform an index unless it is significantly different from an index?  Many skeptics point to the fact that most funds underperform their benchmarks as evidence that active management is a foolish endeavor.

The Active Share study suggests a more nuanced view: The more important indicator of performance is not that a fund is actively managed, but rather how a fund is actively managed.  Funds that have an enormous overlap with benchmark holdings but have [higher] fees for active management must overcome significant headwinds in order to outperform.   

Although portfolios with high Active Share have significant advantages, they also have drawbacks.  The main one is that concentrated, “best ideas” portfolios can be volatile in the short-term.  Impatient, short-term investors can easily be frustrated by this approach.  More sophisticated investors, on the other hand, tend to have a long-term investment horizon and can take short-term volatility in stride.  Further, they also understand that what matters most are fundamental underlying values — which can vary from market prices for significant periods of time.

At the end of the day, sophisticated investors are really just trying to get a good value from the fees they pay their money managers.  They understand that Active Share is a good indicator that a manager is playing to win, to outperform.  They also understand that there are a lot of other ways to make money in the business which don’t provide as much value to investors. 

Since Arete’s strategy was borne from experiences in the large institutional market, its value proposition reflects the accumulation of knowledge and insight from the toughest critics.  One of the highlights of that strategy is a relatively concentrated portfolio of “best ideas” that boasts an extremely high Active Share of 92.5%.  These ideas are the product of intense fundamental research and modeling and represent the unique findings of the portfolio manager.  We work hard to deliver the kind of value large, sophisticated investors expect.

The difference with Arete is that you get the same kind of service available with a $100,000 account that is normally only available for $10 or $100 million accounts.  Wouldn’t it be nice to compete on a level playing field for a change? 

Insider’s View

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  Another is to share with you some of the tips, tricks, and other tools we have incorporated into our work in order to demonstrate how we engage in our craft. In both cases, we hope to provide you some background and understanding so you can better evaluate the many investment services available.

Business involves tradeoffs and this is certainly true for investment management.  In virtually any business, there are a number functions such as marketing, finance, and operations which are necessary to deliver the end product or service.  In large companies, these departments often become functional silos.  In smaller companies, these activities are often outsourced to external firms. 

These organizational structures have the potential to provide benefits in the form of functional expertise and cost efficiency.  Having good pieces doesn’t always make a great machine, however.  When the parts are not well coordinated, friction arises, things slow down, and things can fall through the cracks.  At worst, differing agendas can lead to internecine warfare.  In all cases, quality can suffer.

We can cite many examples of the costs of poor coordination.  We often see the benefit of a skilled portfolio manager eroded by high mutual fund marketing fees.  Often legal agreements are written with the intent of unilaterally benefitting the lawyer’s client, without reference to the goal of a mutually beneficial relationship.  Good intentions for stewardship can be undermined if insufficiently managed back office operations fail to provide timely and adequate disclosure. 

Conversely, when every aspect of a business is consistent, the overall impact can be transcendent.  One of the most illustrative cases is that of Steve Jobs and Apple.  Through his vision and innovations, Apple’s iconic products have resonated with consumers in many important ways. 

One of the hugely influential innovations Jobs brought to commercial products was the graphical user interface (GUI).  It was notable in itself that Jobs created a step-function transformation in the way people interacted with computers.  It is also notable that the motivation for the endeavor was a vision of what consumers wanted, but had not yet expressed.  They didn’t know what was possible.

Another unique contribution of Jobs was the holistic vision he had for Apple.  From the beginning he made sure that each aspect of a device was integrated with others.  Software was integrated with hardware.  He wanted devices to be simple to use, robust, and elegant.  He even went so far as to ensure physical design, marketing and packaging were all reflective of this.  The cumulative effect of this vision produced things that seemed to be of a higher order of quality than anything else.

The distinctive approach Jobs employed through Apple was artfully illustrated in a series of extremely successful commercials featuring Justin Long (personifying Apple) and John Hodgman (personifying PCs).  The key point of the commercials was to highlight the differences in user experiences.  Any user of PCs could relate to countless annoyances like setting up hardware, having software conflicts, having the computer freeze and having to reset, constantly defending against viruses, etc. It all seemed like work.  It was easy to look with envy on Apple which was easy to use, was reliable, and was even fun.

While Arete makes no claim to rival the achievements of Apple, there are important similarities in the approaches to serving customers. 

For one, Arete also has a vision of what customers (individual investors) want.  In our case, it is not anything as innovative as the GUI, it is simply what the big institutions also want.  They want good value from their service providers, they want security and transparency, and they want to know their manager is completely dedicated to working on their behalf.  Arete is fairly unique in making all of these attributes available at such a low minimum investment. 

Another similarity Arete has with Apple’s approach to serving customers is its holistic approach to investing.  Arete works hard to ensure all of the elements of the investment business are thoroughly integrated and consistent with the company’s mission of functional excellence in money management.  For example, while we take the same intense and active approach many hedge funds take to generating performance, we refuse to charge the high fees they do because it detracts from the benefit to our clients.

All of this goes to say that structure matters.  There just aren’t many “Apples” in the money management world.  That’s absolutely not to say that there aren’t a lot of really good, smart, well-intended people; there are.  However, and it is a big however, what any individual advisor can do for you is significantly constrained by the structure and policies and practices of that advisor’s employing firm. 

At the end of the day, most investors feel the same way about their investment programs as their computers; they just want them to work. If your investment program isn’t working, or if it requires too much attention, please let us know.  You may be surprised how much value you can get.

Welcome

With all of the volatility we have seen in the markets the last several weeks, I thought it would make sense to dedicate this edition to sorting out some of the issues.  I have heard a lot of commentary lately, as I am sure you have.  Much of it is confusing, some is misleading.  I’ll do my best to cut through the noise and to provide something helpful.

First and foremost, I don’t see the causes of recent volatility as new phenomena.  This storm has been brewing and I have made mention of significant and underappreciated risks on several occasions over the past year and a half.  We have known that US debt is unsustainably high.  We have also known that the European Union has serious problems with sovereign debt.  In light of these clearly serious problems, I am surprised stocks have performed as well as they have.

I also don’t believe the wild volatility of the markets the last few weeks sheds any new light on underlying fundamentals.  Water has been building up behind the dam for a long time.  The only difference is that now it is starting to spill over the top.  This is not to say, though, that recent price moves are entirely devoid of information content. 

Pressure on stocks in one direction or another reflects motivations of the marginal buyer and seller.  With most market indexes and their valuation metrics hitting highs this year, there has been no reason to buy broadly on the basis of long-term value.  Conversely, long-term value sellers have had plenty of chances this year to liquidate and most likely have done so well before August.  As a result, we can infer that most recent trading activity has been motivated by short-term concerns. 

This insight is useful in two respects.  For one, because recent trades appear to be short-term oriented, they say virtually nothing new about long-term intrinsic values. 

Also, trading volumes have been low, trending down, and seasonally low during the summer.  In the context of low volumes, it is not at all uncommon that price swings become amplified.  The bottom line is that the stock market as a whole probably overshot on the way down in 2009, overshot on the way up earlier this year, and is fairly valued somewhere in between.

I enjoy discussions like this because they highlight some of the strengths of Arete.  One of those strengths is providing useful, objective perspectives.  I think sharing professional knowledge in a clear and straightforward way is a core requirement for any fiduciary. 

Indeed, studying and deriving useful insights is also one of the great benefits of what I do.  I get to read a lot of research from some of the best minds around the world.  The really good news is that there are a lot of extremely smart people thinking about excessive debt and other issues and they share a lot of constructive and creative ways to address them.

On the other hand, one of the challenges I face is filtering out all of the commentary that is not useful.  Unfortunately, there are also a lot of people who are not nearly so helpful (See Lessons from the Trenches).  One of the reasons I founded Arete was because I thought there was an opportunity to better represent and better serve investors by always putting their interests first.  I take great pride in doing so.

If you have questions or would like to follow up with anything I address, please always feel free to call or email.  Also, if you know of anyone else who may be interested in my analysis, please also feel free to forward this letter to them.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights

We spend a lot of time at Arete trying to understand exactly what risks we are taking when we invest money on behalf of our clients.  In the process, we read and review a lot of research in order to arrive at an unbiased view.  Because we are so singularly focused on acting in the best interests of our clients, we call it like we see it, even if that call may impede our ability to increase assets in the short term.  It also means our perspective often differs from the commentary of many of our competitors.

As we see it, there are three big, global problems right now.  We believe the biggest one, and certainly most immediate for US investors, is the excess amount of debt carried by government and consumers.  As Mohammed El-Erian, of PIMCO, describes succinctly, “It’s all about balance sheets.”  Willem Buiter, Chief Economist for Citigroup, highlighted the degree of the problem at the CFA Annual Conference in Edinburgh, “US debt to GDP is around 130% if Fannie Mae and Freddie Mac are included.”  For context, Ken Rogoff and Carmen Reinhart identify 90% of debt to GDP as the approximate threshold at which debt becomes so burdensome as to meaningfully impede GDP growth in their book, This Time is Different. 

Seth Klarman, from Baupost Group, aptly summarized conditions in his annual letter this year, “The national economy had grown dependent on our living beyond our means.”  John Mauldin describes it more colorfully, “The biggest bubble in history is the bubble of government debt.  It is a bubble in a world full of pins.”  To be clear, this is not some obscure, economic blather.  It is big, it is real, and it affects all of us.  The potential consequences, in varying degrees, are lower asset prices and a lower standard of living.

Of course, this is not the first time countries have become burdened with debt.  As a result, there is a wide array of experience and potential policy responses to consider for reducing the debt burden.  The most direct option is to simply allow markets to operate freely by re-setting prices lower when and where prices are disconnected from economic reality.  Other alternatives include inflation and financial repression (in the form of artificially suppressed interest rates).  Unfortunately the outlook for careful consideration of the pros and cons of each approach is not positive.

Despite the enormous significance of the debt problems, political and policy response has been abysmally lacking to date.  Klarman describes, “The imagination of our financial leaders remains so shallow that their response to a crisis caused by overleverage and excess has been to recreate, as nearly as possible, the conditions that fomented it, as if the events of 2008 were a rogue wave of financial woe that can never recur.”  Ken Rogoff, professor of public policy and economics at Harvard, added in a recent FT article, “The biggest deficit is not in credit, but credibility.”

So how will things play out?  What do we expect to happen?  Again, the news is not positive.  El-Erian provides his outlook, “Nothing suggests any of this will be handled competently, let alone smoothly.”  Regarding the outlook for policy options, he adds, “We do not expect policymakers and politicians to show the resolve required to boldly address the structural problems that currently hamper the global economy.”  As a result, we likely end up with a world that, “heals slowly and unevenly, and remains structurally impaired.” 

Russell Napier, author of Anatomy of the Bear, corroborated these views at the CFA Annual Conference, “The politicians should attack these problems with interest rates, but they don’t have the guts.”  Just to make sure there was no misunderstanding regarding his views on policy response, he added, “There is no end to the deviousness of a government on the verge of bankruptcy.”

Very broadly, we see public policy significantly biased towards taking short-term benefits at the expense of long-term prosperity.  In other words, current policy is antithetical to investing in our future.  This policy direction is what we find most unnerving, and therefore risky, about the current environment. 

There are ample precedents on which to base this concern.  Jared Diamond, for example, rigorously studied various factors that contribute to the success and failure of different societies in his book, Collapse. According to Diamond, despite various factors that can affect any particular society, only one, “society’s responses to its environmental problems—always proves significant.”

It is important to understand that to date, we have been huge advocates of the vitality of the US economy and capital markets.  We still are, and we remain very significantly invested in them.  They aren’t perfect, but they are very, very good.

A couple of things have changed recently though.  One is that the magnitude and potential consequences of our current challenges are extremely serious.  Further, we do not believe the seriousness of these challenges is appropriately discounted in market prices.  Insofar as this is true, many people will likely have less for retirement than they think they do.

The second thing that has changed is public policy direction.  It doesn’t surprise us that our politicians are avoiding difficult problems.  It absolutely concerns us that avoidance has continued for so long, even in light of such dire consequences.  We do believe the US economy will pull through, but we will be watching policy responses carefully as a guide for our path to recovery. 

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  Due to several requests from readers, we are creating a new section to expand upon the scope of our “Insider’s View.”  “Lessons from the Trenches” will highlight our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

Much like high quality raw materials are necessary to manufacture high quality products, so too is good information required for good investment results.  As a result, an important part of our research effort at Arete focuses on filtering through the piles and piles of news, research, and data and refining it down to only the most useful elements.

It probably shouldn’t be too surprising that the most useful elements are not always those that make headlines in mainstream media.  I heard a fascinating discussion of this phenomenon by Gillian Tett of the Financial Times at a presentation at the University of Baltimore about a year and half ago. 

When Tett began reporting on US financial markets in 2004, she found, “there was a big discrepancy in how media was covering finance and what was happening.”  Having earned a Ph.D. in anthropology, she saw striking parallels with concepts outlined by French anthropologist/sociologist, Pierre Bourdieu (1930 – 2002). 

Tett elaborated on Bourdieu’s ideas in a guest lecture at Princeton University in April 2010.  Bourdieu believed that “an elite group [can] control society not just by controlling the physical means of production but also by influencing the cultural discourse.  Crucially, influencing the way society talks about itself also influences what is left unsaid — i.e. that which is regarded as impolite, taboo, boring, or taken for granted.” 

What is left unsaid creates a “social silence” that can be used to avoid difficult topics and can engender complicity.  Tett believes, for example, social silence could have been an important factor in general acceptance of self-regulation of financial markets.

The influence of both what is discussed, as well as what is not discussed, shapes the “cognitive map” of a population.  The recent discussion of the debt ceiling provides an excellent example.  While the media focused on the rancorous debate and partisan politics, the hugely important policy issues of restructuring debt and improving job growth were conveniently “silenced.”

Since high grade information is enormously important to the manufacture of good investment results, we exercise great care in identifying pockets of social silence.  This often allows us to “hear” things that other may not, with the goal of forming a more complete cognitive map. 

To accomplish this, we implement several checks to ensure information quality.  At the very least, we always leverage our experience with various information providers.  We seek quality, sustained over time, and deliberately de-emphasize entertainment value (which often serves as a distraction).  In addition, we vastly prefer providers who communicate clearly and honestly.  The harder it is for us to understand them, and the more we have to adjust for their “spin,” the less valuable their services are to us.

Several other approaches also help to circumvent the limitations imposed on cognitive maps.  For one, we seek multiple sources.  As John Hussman, of the Hussman Funds, describes, “The only way to get at the ‘truth’ is to look for a convergence of signals that share common information components but whose ‘noise’ components aren’t terribly correlated with each other.”  Multiple sources and multiple signals allow us to triangulate on important insights.   

Closely related to the multiplicity of sources is diversity of those sources.  Our goal is intellectual honesty and that is best achieved by finding sources and arguments that seriously challenge our own thinking and assumptions.  Two of our primary media sources are based in the UK, The Financial Times and The Economist.  In addition to being fantastic sources of information, both publications provide a perspective on US matters that is virtually unattainable for US-based publications.

Finally, part of the value of cognitive diversity is that it vastly increases the chances that a source may dare to be irreverent.  Information or topics that are regarded as “impolite, taboo, boring, or taken for granted,” in one cultural context, may be very fair game in another. 

Corporate culture tends to have a lot of taboo topics which is why we generally prefer more independent sources.  This is especially true of banks, investment companies, and other financial services firms.  They have too much business riding on optimistic outlooks to allow much meaningful discussion of problems or challenges.  It also explains why we get so much out of the CFA Annual Conference — because it’s not sponsored by a Wall Street firm which may have incentives to control the cognitive map.

Good information is important for any enterprise, and especially so for money management.  In addition to providing insights into the underlying reality of investments, it also provides a clear view of the risks related to various investments.  We spend a lot of time at Arete trying to understand the nature and magnitude of risks we take on behalf of our clients.  Because we are so singularly focused on acting in their best interests, we want to be right.  For that, we often need to explore what has been left unsaid. 

Welcome

I’m just returning from the CFA Annual Conference in Scotland so what better subject to discuss than golf!  It’s not that I’m a particularly avid golfer, and certainly not a very good one.  However, I do enjoy playing once in a while and have played enough to appreciate how fiendishly challenging it can be at any level.

I can also appreciate how phenomenally good the pros are.  They have shots for every condition and every situation.  They can shape their shots to the fairway.  They are remarkably strong and flexible.  On top of it all, they are incredibly consistent.  When a novice makes a mistake, he or she whiffs and misses the ball completely.  When I make a mistake, I slice my drive 80 yards into the trees.   When pros make a mistake, their 300+ yard drive gently rolls into the rough. 

We all understand such exceptionalism intuitively.  We watch professional sports to see the very best athletes.  We read books written by the smartest and most creative writers. We watch great actors create scenes on TV that are so realistic as to engage our attention and emotions. 

Most people also easily understand excellence relative to their own areas of expertise.  What have you done in terms of education and practice and commitment to get really good at what you do?  Is it easy for “non-professionals” to replicate your skills?  Can amateurs match your success by just getting lucky?  Could they sustain that success over a long period of time?  For most people, the answer clearly is, “No!” 

Despite the natural tendencies to admire and seek out exceptionalism in most parts of our lives, I am always surprised by how many people seem to reject or avoid exceptionalism when it comes to investing.  Some have even worked pretty hard to “prove” that skill is irrelevant to investing.  They believe skill cannot meaningfully differentiate returns.

There are a couple of reasons why people treat investing differently than almost every other part of their lives.  The first reason is that when you watch exceptional athletic performances, the results are obvious and immediate.  When someone chips out of a bunker and holes it, you know it’s a great shot. 

With investing, however, things are far less obvious.  It can be months or years before great analysis is finally realized.  Even then, because of time lags and indeterminate future events, great analysis is not always realized in the form of outperformance.  Sometimes the value of quality analysis reveals itself more in loss avoidance, risk management, or robust portfolio construction.  Regardless, it is very difficult to accurately infer skill from performance with investing, especially over short time periods.    

The second reason why people treat investing differently is that the field is wide open.  Most competitions are closed to amateurs and novices.  Not so with investing.  Virtually anyone can play as long as they disclose what they do.  This makes for a very crowded field with participants spanning the entire spectrum of talent levels.

This “open” format for investing further adds to the difficulty of judging skill.  Given the incredibly large number of competitors, it is virtually impossible to fully evaluate all of them.  As a result, about the best one can do is to watch a relatively small number of participants for long enough to make an assessment.  This takes time and effort itself, and many find it easier to avoid the evaluation process altogether. 

This is unfortunate, because exceptionalism exists in investing, just as it does in every other human endeavor.  Think of it this way: What if you found someone who invests the way you would if investing was the one thing you devoted your entire career to getting exceptionally good at? 

I founded Arete to be a great investing partner.  If this sounds like an interesting proposition to you, please let me know.  Perhaps Arete could be a good fit with your investment needs.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights

Have you ever been in a position when you paid more for something than it was probably worth, but the convenience was important to you?  Perhaps you needed milk and the 7-11 was much closer than the grocery store.  Or maybe you were travelling and it was just easier to pay $20 for a burger at the hotel restaurant.  In both cases, time and location are important variables.

This business arrangement is common in many industries.  It involves adding intermediaries, often known as “middlemen”, to a supply chain in order to improve distribution.  In other words, it makes it easier for people to get things.  The tradeoff, however, is that it costs more to get those things.  It is common to find such arrangements for relatively low cost, short-lived products for which convenience is imperative. 

The last place one would expect to find such arrangements is with relatively expensive items that have long lives.  Because these items involve more money, we would expect buyers to do more research to get a good deal.  Also, since these items are intended to be long-term, convenience provides very little benefit.  For example, all else equal, why would you pay 50% more for a house in order to buy it quickly?

Oddly enough though, this is exactly what happens with a lot of investment products.  According to a draft IBM report noted in the Financial Times, “An army of consultants, advisers and distributors has emerged to act as middlemen in recent decades, distancing the global asset management industry from its ultimate customers.”  In the process of distancing asset managers from customers, “increasingly powerful distributors [are] taking a greater share of the spoils, at the expense of asset managers.” 

The bottom line is that the industry is “paid too much for the value it delivers.”  While there is plenty of blame to go around, there is no doubt that more and more powerful middlemen are extracting significant sums from investors.  In the face of the headwinds of lower economic growth, and lower discretionary income for many people, investors continue to pay a premium for convenience by shopping at the “7-11” for investment products. 

An alternative course of action is to accept less convenience in return for lower costs by avoiding intermediaries.  The technical term for this practice is called “disintermediation” and was one of the theses behind the internet boom.  Just like it is cheaper for people to buy books on Amazon than at a Barnes and Noble, so too it is cheaper to buy many investments directly through a money manager than through a broker or adviser. 

Importantly, many investors may value the services of a broker or adviser, just like they may find it useful to actually visit a bookstore.  The main point, though, is that when you are on a budget, it is important to pay only for what you really need.  This is doubly important with investing because any fees avoided can also be invested.

Arete was built on the idea being able to offer an extremely affordable, actively managed portfolio by keeping marketing costs as low as possible.  We don’t like paying up for things we don’t need so that is what we also offer to our clients.  We provide a great deal of information on our website at www.areteam.com so you can evaluate our offering in a very cost-effective way.  Further, we are always available by email and phone if you have questions.  Please let us know if you are interested!

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  Due to several requests from readers, we have created a new section to expand upon the scope of our “Insider’s View.”  “Lessons from the Trenches” will highlight our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

The Baltimore CFA Society (BCFAS) recently hosted an educational luncheon featuring Jim Valentine, author of Best Practices for Equity Research Analysts and founder of AnalystSolutions.  This type of event is a great example of the value BCFAS provides its members, but is also a great example of how BCFAS makes investment-related insights available to the broader community.

Having been a top-rated Wall Street analyst for several years, and having served as Director of Training for Morgan Stanley’s global research department, Valentine has strong credentials in equity analysis.  One might have expected him to come out talking about esoteric modeling tools and the like.  Instead, he offered a much more philosophical approach, which in many ways amounted to lessons for knowledge management.  Three of the key lessons he shared apply equally to individual investors as to professional analysts.

The first lesson is that investment calls need to differ materially from consensus. 
This is often difficult for individual investors to fully appreciate.  If you hear an idea on CNBC or read it in the paper, the chances are millions of others are doing the same.  As a result, the idea gets discounted very quickly and efficiently yielding no special benefit. 

One way to gauge the uniqueness of an investment idea is to consider exactly how it differs from consensus.  Do you have a much more accurate financial forecast?  A better valuation approach?  Or do you understand sentiment around the stock better?  If you don’t, you don’t stand much chance of beating the market.

Another lesson is to be selective with information.  In a world where information is cheap and prevalent, the analyst’s job is to efficiently filter out the stuff that is just background noise, so he/she can focus on the things that really matter.  We simply do not have the time to do everything and need to choose wisely.  What are the two to four critical factors that really drive the stock?  If you don’t know, you may be focusing on the wrong things.

Finally, it is important to have some edge or competitive advantage.  Lots of very smart people are all doing the same thing trying to make money.  What makes you special?  Do you have an especially effective valuation methodology?  Do you have proprietary information resources?  Whatever it is, you need something to stand out from all of the others.

At Arete, our research effort is absolutely core to the mission of delivering functional excellence in money management.   These are the things we do every day. 

Welcome


I love books and one of my favorite book titles is Philosophy: Who Needs It.  I am partial to the subject because I studied philosophy extensively as an undergraduate.  I am also amused by the irony.  At the mention of philosophy I can almost hear someone ask sarcastically, “Who needs it?” 

The book was authored by Ayn Rand who is far better known for her epic novels Atlas Shrugged and The Fountainhead.  Rand believed, “Philosophy plays a central role in all human activities . . . Every action, every thought, has at its root certain assumptions and that we need to examine those assumptions to live a full, meaningful life.” (Wikipedia)

I often have a similar feeling about the investment landscape.  Perhaps I could write a book called Investment Management: Who Needs It.  As Rand argues regarding philosophy, I could argue that investing plays a central role in our well being.  I could also argue that investment actions, and inaction, have certain assumptions that need to be examined to fully realize retirement goals.

For most of us, assumptions are largely based on our experiences.  Our experiences are shaped into mental models that help us understand how the world operates.  Most of the time, these models tend to be fairly efficient and effective in guiding our daily actions.

The major exception to this general rule is when our past experiences are limited relative to the set of conditions we may face in the future.  This was a key theme of Nassim Nicholas Taleb’s book, The Black Swan.  The idea is that not only can things happen outside of our normal set of experiences, but these “anomalies” can have a big impact on our lives.

For many, assumptions have been shaped by the economic experiences of the last thirty years.  This was a period of strong economic growth, strong investment returns, and low inflation.  In short, the investment experiences we have had that seem “normal” to us, are decidedly abnormal in the broader context of history.  We have had the great good fortune to live through investment nirvana.

Many investors, naturally, are using this experience as the basis for making retirement decisions.  They have watched funds appreciate with the markets over time.  They know many people before them who have retired comfortably and expect the same.  As a result, I believe many investors are assuming they just need to “wait it out” in order to retire comfortably themselves.  I believe this is an extremely dangerous assumption to make.

For better or worse, I see a very different intermediate future for investing.  Although there are several reasons that support my view of more challenging markets going forward, I will list three here. 

First, the bull market from 1982 to 2000 stands out as unique in the history of investing.  Returns were exceptionally high and well beyond historical norms for both equity and fixed income.  Fixed income returns have remained strong providing a fortuitous boost to those shifting allocations away from equities in preparation for retirement.  Based on valuations and historical experience, there is every reason to believe that market returns will be lower for the foreseeable future. 

Second, the work force in the U.S. is aging, as it is in many developed economies.  This matters because as Baby Boomers begin to retire, they also move out of the most productive parts of their careers.  Since productivity is a key driver of economic growth, growth will slow directly as a function of this demographic shift.

Third, public and private debt is at extremely high levels.  All historical evidence points to the fact that it takes a long time to work debt levels down.  We are in the very early innings of this deleveraging process and the effort this time will be impeded by demographic forces. 

I don’t in any way wish to scaremonger or to coerce people to believe “the sky is falling.”  It is not.  But I do hope people take Rand’s advice.  Challenge the assumption that you don’t have to do much to plan your retirement.  Reconsider your retirement plans by incorporating a far less friendly investment environment into your assumptions.

I offer these challenges for a few different reasons.  For one, I think it is always a healthy exercise to challenge assumptions to make sure you stay on the right track.  Second, I believe there are a fair number of people who are relying on too rosy forecasts to meet their retirement goals.  Finally, the downside risk is substantial.  It is extremely difficult to make up savings deficits after retirement.

For those who find they are not on track to meet retirement goals, it is far better to find out early rather than late.  If you find out early, the challenge is manageable; action can be taken on several fronts.  To me the best response is to work hard, save as much as you can, and do everything possible to invest those savings well. 

On that note, I have always believed that investing plays a central role in our well being.  I created Arete because I thought there would be a demand for good investing — characterized by superior performance and lower fees.  I have never believed that more than I do today. 

Please let us know if we might be able to help you.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights

Have you ever seen a sign or a warning label that caught your attention as being absurdly self-evident?  "Do not use in shower" was on a hair dryer.  "Do not use while sleeping or unconscious" was on a hand-held messaging device.  When we see things like this we are often amused, and sometimes confused.  Then our curiosity takes over and we wonder what happened to cause a need for such a label?”  

We came across a similar situation three years ago when Arete was formed.  In the process of becoming registered as an investment advisor, we had to fill out the form ADV.  In doing so, we often found that the questions defied comprehension.  Eventually, though, we realized that each question on that form is there for a reason: It represents some way that some advisor deceived, manipulated, or abused investors.  Now each question serves as a type of warning label.  We have actually come to view the form ADV as a chronicle of malfeasance in the investment industry.

This is actually a pretty useful insight and one that individual investors can use to their advantage.  Most people consider the security of their investments to be of paramount importance — and rightly so.  Nobody wants to be a Madoff victim. 

The good news is that all of the information and disclosures presented in form ADV are easily accessible to the public.  Every registered adviser can be investigated through the Investment Adviser Public Disclosure website at:

http://www.adviserinfo.sec.gov/%28S%28ysxtjxrktchep32xyu5fal45%29%29/IAPD/Content/IapdMain/iapd_SiteMap.aspx

All of the warning labels are there for you to see.  Whether you completely read through several different ADVs or do some spot checks to confirm certain important points, it is a useful exercise.  Further, it is as easy as sitting at your computer for a few minutes. 

Interestingly, this exercise is not so much one of “finding a needle in a haystack” as many may believe.  A couple of recent articles about hedge fund risk provide an interesting glimpse into the business. 

In one study of a group of hedge funds, researchers found that one in seven reported at least one infraction of legal, disciplinary, or regulatory compliance (“Estimating Operational Risk for Hedge Funds: The ω-Score”, Financial Analyst Journal, and “Can Hedge Fund Operational Risk Be Quantified?”, CFA Magazine).  In other words, this isn’t a wild goose chase; there are a lot of problems and many are out in the open for investors to see. 

The research revealed two more very interesting insights.  First, while most due diligence efforts focus on investment research process and financial condition, studies suggest this effort may be misguided.  Operational risk “has been shown to be a better predictor of fund failure than financial risk.  More specifically, “an astounding 50 percent of hedge fund failures could be attributed to operational issues.”

The second interesting insight is that, “the likelihood of poor subsequent performance increases with exposure to operational risk.  This suggests that operational factors such as disciplinary violations do more than warn against fund failure.  These factors are also associated with fund performance. 

To sum up, warning labels exist for a reason and nowhere is this more important than the investment management business.  The reality is that the industry is characterized by managers with an extremely wide array of ability and ethics.  With no formal requirements for educational and professional standards, anyone can give it a shot. 

While this condition creates a challenge for investors, there are tools that can help.  Research is pointing the way to more effective and efficient due diligence processes.  The evidence strongly suggests that efforts can be improved by focusing more on operational issues.  Also, the Investment Adviser Public Disclosure website is a great resource by providing easy access to the ADVs of registered advisers and therefore to the most important operational issues. 

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  Due to several requests from readers, we are creating a new section to expand upon the scope of our “Insider’s View.”  “Lessons from the Trenches” will highlight our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

Arete is unique in many of the things it does and one great example is the way we integrate proxy voting into our research process.  Many firms view proxy voting as a non-core function and outsource it to third parties.  I view it as yet another opportunity to gain insight into companies and to best represent the interests of Arete’s clients.  How can that be “non-core” to an investment operation?

Many people rank reading proxies right up there with watching grass grow and I can’t say I felt any different when I started as an analyst.  Lots of gobbledygook, and for what?

My conversion began with my quantitative and modeling work early in my career.  I knew very well from that experience that as useful as models could be, they were still always imperfect representations of reality.  I also knew the value of models were only as good as their inputs: Garbage in, garbage out.

As a result, I found the best way to use a model was not to blindly grind data through it.  Rather, it is important to pay attention to the quality of the data and to understand how it might be biased.  In other words, it is important to calibrate the data based on the context from which it is created.

When you look at hundreds and hundreds of companies, you realize the same numbers can mean different things.  Some management teams under-promise and over-deliver.  Some are eternally optimistic and do the opposite.  Many have identifiable tendencies.  In order for these to be comparable and useful in a model, they need to be adjusted.  

As a result, I started paying more attention to any research that might tip off the tendencies of a management team.  In the process of looking at proxies more carefully, I noticed some interesting patterns.  For example, I noticed many compensation plans are structured such that a very modest improvement in fundamental performance produces a very large increase in incentive compensation.  Such a “tipping point” can provide useful insight into consensus forecasts and a useful signal of management’s intent. 

Another signal of management’s intent can be found in the metrics used to determine incentive compensation.  While almost all metrics involve assumptions from management, some are more prone to outright manipulation than others.  I have found, for example, that earnings per share is used fairly widely in plans and is also particularly susceptible to manipulation. 

Signals by themselves don’t prove anything, but they do provide information which can be used productively.  One thing I do is to consider each of a company’s accounting and other policies together as a “mosaic”.  Do the policies tend to be aggressive or conservative?  Do the policies and governance practices tend towards self-interest on the part of senior management or towards fiduciary duty to shareholders?  In both cases, the answer provides a context from which to calibrate the fundamental metrics. 

My standard of quality in this exercise is a successful partnership.  Arete invests money with management teams to make business decisions on our behalf.  An important part of my job is to determine whether or not the business is a good one to invest in.  It is underappreciated, however, how important it is to also have a good partner.  If the partner is continually searching for ways to hive off more of the profits for himself at our expense, it will have to be an exceptional business for us to realize any benefit. 

Howard Schillit aptly describes the analytical exercise in his book, Financial Shenanigans.  The focus of the book is primarily on various ways in which management teams can manipulate accounting numbers to their own benefit — and how investors can spot these tricks. 

As Schillit describes, “Companies with structural weaknesses or inadequate oversight provide fertile breeding ground for shenanigans.”  He goes on to recommend that analysts should probe for strong governance in the form of appropriate checks and balances, strong Board members to protect shareholder interests, knowledgeable and independent auditors, and any efforts to circumvent regulatory scrutiny. 

Many investors and analysts still prefer to forego the practice of reading proxies and instead rely on industry and media sources to provide shortcuts.  Schillit notes this practice is imbued with its own risks: industry magazines can get things terribly wrong.  For example, he cites, “Recipients of CFO magazines respected Excellence Awards include the 1998 winner, WorldCom’s Scott Sullivan (currently in jail); the 1999 winner, Enron’s Andrew Fastow (currently in jail); and the 2000 winner, Tyco’s Mark Swartz (currently in jail).”  

In sum, I have become a big fan of proxies because of the informative signals they can provide.  Reading and voting proxies improves corporate governance, improves the quality of research, and provides important warning signs.  The proxy process is completely integrated with Arete’s research effort and is absolutely core to its mission of delivering functional excellence in money management. 

Welcome
Because I am an analyst at heart, I am better at providing a long list of things that Arete does differently from the mass of other investment offerings than I am at articulating a single idea that captures the essence.  After a lot of consideration though, I have found the essential difference is that before all else, I am an investor.  

What I mean by this is that Arete is purely and simply a representation of what I consider to be best practices for investing.  My top priority has always been to generate superior investment returns. 

Being the inquisitive sort, I wanted to better understand the source of this tendency.  I believe it mostly derived from when I was growing up in Iowa.  I had a problem in that I was ambitious and driven by intellectual challenge.  I knew early on I probably had to go to college to fulfill my intellectual pursuits, but I also knew I probably couldn’t afford it.  For better or worse, I felt that doing nothing was a terrible option.

I worked all the odd jobs I could find, saved my money, did well in school, and through several scholarships, loans, work-study, and grants, I was able to attend Grinnell College.  The education and experience made my life immeasurably better.  This was my first really big investment, and it worked. 

My investment experience since has been similar.  My circumstances have largely been such that I could not afford to do nothing.  Going nowhere was not an attractive option.  Nor did I have the luxury of taking extravagant risks because I did not have a safety net to catch me if I fell.  I have had opportunities though, and this is actually what Arete is all about.   

Arete is about carefully managing risk and seizing attractive opportunities.  It is designed to be extremely functional – to be long on things that actually help make investors better off, and short on costly peripheral items that do not.  It was designed to be a very fair value.  In short, it was designed as a solution to my investment problem.  I believe it can serve as a solution for many others as well.

I never thought this “investment” attribute was particularly unique until I worked in some large, complex, investment organizations.  What I found was that the possibility of making a great deal of money in the business attracted a great number of ambitious people.  I also discovered that a good number of them did not know how to invest.  Many of them even knew it, or at least suspected. 

While there have been bad actors in the money management business, as in any other, the more pernicious truth is that there have been an lot of people getting paid quite a bit of money and not helping investors earn better returns.  I don’t believe these people are bad people, at all.  I do think many of them have been primarily motivated by preserving lucrative careers. 

As a result, of the thousands and thousands of “professional” investors, many are not primarily motivated by, and capable of, producing superior investment returns.  In this respect, Arete is quite clearly different.  Neither I, nor Arete, has any vested interest in mediocre returns.  The only way we get ahead is if our clients do.

Finally, since the Thanksgiving holiday is rapidly approaching, I would like to thank all of the people who read my letters and have spent some of their valuable time learning more about Arete Asset Management.  I also would like extend special appreciation to Arete’s clients.  Without your effort to learn about Arete, and ultimately to trust in me and in Arete’s mission, none of this would be possible.  Thank you!

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights

We have been thinking a lot lately about professional trust.  In short, there has been a great deal of “bad behavior” in the investment management business and it has markedly tainted the entire industry.  In various ways, from excessive fees, poor transparency, avoidance or abrogation of fiduciary duty, individuals and organizations in the investment management business have taken advantage of the very people they are supposed to help.  The full impact of such behavior is greater yet because it tarnishes the industry and creates suspicion of everyone, including even the best actors.  Suspicion prevents many investors from actively seeking the services they need. 

In order to better understand the character of misdeeds, to better equip ourselves to avoid problems, and simply to satisfy our curiosity, we studied the nature of dishonesty in people.  One of the best sources on the subject is Predictably Irrational, by Dan Ariely, who is one of the foremost experts in behavioral economics. 

Ariely begins his investigation by differentiating forms of dishonesty.  The first form is a deliberate and aggressive act such as an individual planning to rob a store and then executing the plan.  Such acts are considered significant violations of social codes and typically receive harsh treatment in America’s penal system. 

The second type of dishonesty is, “the kind committed by people who generally consider themselves honest.”  These acts involve things like taking a pen from the supply closet, exaggerating an insurance claim, and the like.  Such acts are fairly common and in some cultures, even rampant.

Through a series of clever experiments, Ariely revealed a great deal more about the nature of dishonesty.  For example, he found, “when given the opportunity, many honest people will cheat.  In fact, rather than finding that a few bad apples weighted the averages, we discovered that the majority of people cheated, and that they cheated just a little bit.” 

He explains that people don’t become wildly dishonest because they fear violating social norms.  Large-scale dishonesty would surely invoke negative opinions from our peers which would be costly.  “The problem is that our internal honesty monitor is active only when we contemplate big transgressions.”  In other words, most mild acts of dishonesty fly under our ethics radar.

This is interesting, but what really is the harm of a few mild acts of dishonesty?  For a baseline figure, Ariely reports a proxy for the cost of the first type of dishonesty.  At the time of his study, “the total cost of all robberies in the United States was $550 million.”  In contrast, as a representation of the second type of dishonesty, “employees’ theft and fraud at the workplace are estimated at about $600 billion.”  In other words, the “mild” form of dishonesty costs the economy more than one thousand times as much as the “severe” form.

Those are the measurable costs.  Perhaps even greater are the costs associated with erosion of professional trust.  Originally, “individuals who had mastered esoteric knowledge, it was said, not only had a monopoly on the practice of that knowledge, but had an obligation to use their power wisely and honestly.” 

However, in the 1960s, Ariely describes, cultural trends moved to deregulate professions in order to reduce elitism.  While perhaps well-intended, the unfortunate outcome was that “strict professionalism was replaced by flexibility, individual judgment, the laws of commerce, and the urge for wealth, and with it disappeared the bedrock of ethics and values on which professions have been built.”  Professionals felt freer to engage in mild acts of dishonesty such as padding hours and inflating fees. 

These trends were brought into perspective a couple of weeks ago when we heard Thomas Friedman speak.  Friedman, the New York Times columnist and author of The World is Flat, was concerned that we (the U.S.) have lost our direction by trading “situational for sustainable values.”  More specifically, he lamented, we have “underpriced risk, privatized gains, and socialized losses.”  We believe too many CEOs, professionals, and other leaders have been the worst offenders. 

To his great credit, Ariely does more than discuss research, he also offers several prescriptions.  For example, he says, “Another path [to honesty] is to first recognize that when we get into situations where our personal benefit stands in opposition to our moral standards, we are able to ‘bend’ reality, see the world in terms compatible with our selfish interest, and become dishonest.  What is the answer, then?  If we recognize this weakness, we can try to avoid such situations from the outset.”

His suggestion of identifying and avoiding potential conflicts of interest sounds simple enough, but is itself subject to reality ‘bending’.  After all, for those so motivated, what constitutes a conflict?  Certainly, it might be argued, just because some activities are extremely profitable for a firm does not ensure such activities are not also valuable for its clients.  One large financial firm provided an extreme example of this vulnerability when it “actively and consciously embraced conflicts of interest”.

As readers of the latest Arete Quarterly know, one of the best ways to avoid decision making errors is to add perspective by applying the “outside view”.  In other words, what works in other comparable situations? 

This is exactly the approach we apply at Arete.  We ask which situations could involve a conflict of interest, and then we challenge that further by asking where there may even be the appearance of a conflict.  Then, to the extent possible, we structurally eliminate the possibility of conflicts.  This is why we have no soft dollar arrangements, why we have a simple product and business model, and why we provide all clients full time visibility to all of their holdings. 

We aren’t going to claim we are more honest than everyone else.  But we will claim that we try harder to understand human frailties in order to avoid behaviors that can cost clients a lot of money.  This is the best way we know to restore professional trust, and perhaps even to replace situational with sustainable values.  

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  Due to several requests from readers, we are creating a new section to expand upon the scope of our “Insider’s View.”  “Lessons from the Trenches” will highlight our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

So many ideas and tips and experiences go into Arete’s research process that it is difficult to provide meaningful lessons without providing a great deal of context.  I had the opportunity to do just that recently when I presented to an advanced finance class at the Johns Hopkins Carey Business School.  Since these students had already covered accounting, finance, and investment theory, I had the luxury of jumping into some of the more interesting aspects of the process fairly quickly.  I realize many Insights readers may not have the same background in financial theory, but I believe many of the lessons will be useful nonetheless.

In order to provide some context, it makes sense to reiterate Arete’s investment philosophy.  In short, Arete’s research process is designed to find undervalued stocks.  This is so important that we include it with each of our quarterly reports — everything else revolves around it.  Alternatively, some investors pursue philosophies such as momentum trading and market timing.

Of course finding undervalued stocks only works when you have a way to accurately value stocks.  Arete licenses a model from Applied Finance Group which is essentially a very long-term discounted cash flow model.  Detailed discussion of the model would require an advanced finance class of its own and is well beyond the scope of this section.  Suffice it to say, however, empirical evidence and finance theory both support the efficacy of the model.  

There are many different ways in which stocks can be undervalued, but I normally begin analysis by running consensus expectations through the model.  This allows me to see the economic profitability of the company, to see if return on investment (ROI) exceeds the cost of capital, and to see how ROIs are trending.  Importantly, it provides me context from which to judge the quality of management.  For example, if ROI is less than the cost of capital, efforts by the management team to grow company assets would result in destruction of value and would reflect a poor set of priorities. 

It often happens that by simply plugging in consensus estimates to the model, I find a stock that appears undervalued.  Often, this is just appearance.  Frequently, the market may not believe the consensus estimates or it may be pricing in risk factors not captured by the estimates.  Occasionally, though, for various reasons, the market just has something wrong.  While this is very useful information, it also helps to have some understanding as to why the market may be wrong. 

Because of the efficacy of the model, it also serves as a useful interpreter of market expectations.  By creating combinations of inputs that generate a price target equal to current market price, I get a credible quantitative perspective of the market’s expectations for fundamental variables.  For example, based on some reasonable assumptions, I can often determine within a fairly narrow range the level of profitability the market is discounting for a firm.  With this, I can then direct my research to confirm or disconfirm the market’s expectations as viable.

Finally, by running various fundamental scenarios through the model, I can identify credible upside and downside risk to valuation.  Of course that doesn’t always mean market prices will obey, but they do provide a useful framework from which to better understand what can happen with the stock.

There is a lot of information conveyed by the market, but it is difficult to understand if you don’t speak the language fluently.  I spent nearly twenty years learning and practicing the language of valuation for various investment firms.  Now, Arete can serve as an interpreter for both individuals and institutions who appreciate the value active management can provide them.

Welcome


One of the most frustrating things many of us encounter in our daily routines is trying to find good service professionals.  Is your car making a funny sound?  Who do you call?  Does your refrigerator just stop refrigerating every few days — and then start again?  What do you do?  Most of us prefer to find someone we can absolutely trust to both figure out what is wrong and to actually solve the problem for us.  

I don’t think the situation is any different for investment services.  My goal with this newsletter is to share some of the insights I have gained from the day-to-day work of analyzing stocks and managing portfolios over twenty-plus years.  Hopefully you will find some of these ideas helpful in navigating the investment landscape.

Personally, when I begin a search for a service professional, I usually start by asking who I know that might have a good contact.  I normally prefer to find independent professionals who I feel really want to solve my problem.  Many people, however, prefer to employ a large, well-recognized chain.  The first section of this letter will discuss the pros and cons of size as it relates to money management firms. 

Also, many of you have asked for more details about how I analyze and select stocks.  In response, I am introducing a new section to Arete Insights entitled “Lessons from the Trenches.”  This section will highlight Arete’s approach to stock research by discussing various tips, tricks, and analytical tools I have developed that have provided valuable incremental insights.

Finally, if you know of anyone who may be interested in reading this letter, please let me know or ask them to contact me (my contact information is at the bottom of the page) so I can put them on the distribution list.  Arete offers a compelling investment value at least partly by shunning large advertising and selling expenses — I appreciate your help in keeping it that way!

Thanks and take care!

David Robertson, CFA
CEO, Portfolio Manager

Insights

. . . I say tomato

Last quarter we began a discussion about concepts that can mean very different things to different people.  Quality is one such concept, and also one that is core to Arete’s mission.  What makes one firm better than another?  For many, size of the firm can send strong signals — for better and worse. 

The conventional view is that operational risk is greater at small firms.  Small firms often do not have sufficient people, systems, and resources to consistently operate their business.  They are busy scrambling for assets.  Things slip through the cracks.  Conversely, large firms tend to be more fully staffed, better equipped, and can provide more functional expertise.

The alternative view, and one certainly borne by plenty of experience in the money management business, is that operational risk is often greater at large firms.  Organizational culture, power structures, and incentives are tightly linked to firm profitability.  These interests nearly always win out when in conflict with client interests.  Small firms, on the other hand, often exercise far greater care in serving their clients due to personal commitment and reputation.  With everything at risk, they have no other choice.

There is also a widely held view that business risk is greater at small firms.  The conventional view is that small firms tend to be under-capitalized and may not be able to sustain themselves or to exploit growth opportunities.  Large firms, however, often have better access to capital which allows them to slog through business downturns.

Since money management is not a capital intensive business, capital availability is far less important than for most other industries.  What matters a great deal are quality organizational governance and prudent budgetary management.  In these respects, small firms often fare much better because owners tend to have significant stakes in the business. Without such stakes in the business, employees at large firms tend to have greater incentive to manage their careers than to serve clients.

These thoughts were captured well by Henry Higdon of Higdon Partners, LLC.  He stated at the conference, The Changing Face of the Investment Management Industry, “We see a lot of disillusionment and disenchantment with the big firms.  People want to go to smaller firms.  They want to work with people they trust and respect, and they want to make a difference, and the big firms don’t really provide that.”

While it is clear that there are compelling arguments for both sides, perhaps the most important insight resides with the tradeoffs involved.  On one hand, large firms have more resources than small ones.  On the other, clients mean everything to small firms.  Which is more important?

The answer was easier forty years ago.  Large firms could deploy more people to gather information and analyze results.  Large firms could also afford costly computing resources to crunch the numbers.  Large firms then were also tiny compared to the behemoths of today, and were not saddled with the same degree of organizational complexity and conflicts of interest.  Today, much of the bias for large firms represents inertia; technology has slashed the costs of computers, telecoms, and trading thereby substantially eliminating the competitive advantages size once conferred.

Arete was founded with the mission of delivering functional excellence in money management — in other words, quality.  Based on changes in technology, changes in the industry, and dynamics observed through our own experiences, we believe it is now far more important for active managers to be independent and to have skin in the game than to have a few more resources.  Quality demands that size be managed to complement mission.

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  Due to several requests from readers, we are creating a new section to expand upon the scope of our “Insider’s View.”  “Lessons from the Trenches” will highlight our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

One of my most memorable experiences analyzing a company happened in my first job after business school.  It also provided one of my most valuable lessons.  My job was to analyze and model a small radio broadcasting company with about $10 million in revenues and to determine what it was worth.

Like a good bottoms-up analyst, I went about the process of analyzing the financial statements, researching the industry, and looking at comparable companies. 

When it came to valuation, I used the historical financials as a foundation from which to forecast future results.  I used what I believed to be reasonably conservative estimates for revenue growth and margins and ran them out for ten years in a discounted cash flow model.  I calculated a weighted average cost of capital and discounted the cash flows back to present.  When all was said and done, the model indicated that the company had negative value!

Not to be sidetracked, I hunkered down and tested all of my assumptions.  I determined that the revenue growth rates were too conservative and that the margins, although forecast to be higher than they ever had been, could go higher yet.  I still got a negative value!  I pushed and pushed every assumption but to no avail. 

I finally had a breakthrough when I was talking to a radio professional about the industry.  The person mentioned that a radio station has value even if there are no intervening cash flows because FCC licenses have value.  This is called “stick" value.  The concept is very similar to that of a patent and to a zoned/entitled parcel of land.  All of a sudden, things started to make sense and I was easily able to complete the valuation exercise.

This incident taught me a couple of important lessons about analysis and valuation.  First, it reinforced the notion that all models are imperfect representations of reality.  Each model has strengths and weaknesses depending on the specific situation.  While I already knew this, I gained a much greater appreciation for the breadth and variety of special situations I had not yet encountered.

Second, it also taught me that at any point in time, there are several different possible outcomes.  The future is indeterminate.  As a result, analysts need to consider different scenarios and explore the implications of each.  Analyzing scenarios improves as one gains experience with certain industries and types of situations.  In addition, creativity can also prove useful in imagining what might happen that can affect a business model.


In my radio broadcaster exercise, my original valuation analysis was based on only one scenario, that of modest incremental improvements.  As it turns out, it wasn’t even a useful scenario.  Once I researched comparable “stick” values, I was able to provide a reasonable downside valuation (with limited supply, it could always be sold).  Then, I could look at the more successful broadcasting companies as a guide for establishing an upper bound for profitability and valuation.  Finally, I could compare the managers to others in the industry to determine where along the spectrum company profitability might fall.

There are two important takeaways from this example.  First, this is exactly the kind of example I use when I work with younger analysts to help them build their skillsets.  They still need to do all of the nitty-gritty work of stock analysis such as reading and studying industries, public filings, articles, research reports, financial statements, conference calls, company presentations, etc.  Incorporating concepts like “stick” value, however, increase perspective and in so doing, generate incremental improvement in the conversion of analytical resources to portfolio performance.

The second important takeaway is that this exercise highlights the tradeoff between depth and breadth of analysis.  Many investors benefit from the breadth of services a financial planner provides in managing the myriad financial issues associated with a comprehensive investment plan.  Managing such a wide array of issues, while useful to many, makes it virtually impossible to conduct the kind of in-depth analysis that provides real insight into individual companies and securities. 

This is exactly how Arete differentiates itself with individual investors.  By focusing narrowly on our area of expertise, US mid cap stocks, and by continuing to do the rigorous and original analysis we have been trained to do for large institutions, we offer to individuals and small institutions the type of research and access that used to only be available to large institutions.  This proposition should especially appeal to those who appreciate the value active management can provide, but want to make sure their manager knows more about it than they do. 

Welcome

It is not uncommon knowledge that many of the best investors tend to be contrarians — often taking positions that are at odds with conventional wisdom.  While contrarian tendencies have tended to serve me well as an investor, they often complicate the process of communicating Arete’s message.    

The complication arises from the gap between my views and interpretations of things as a contrarian investor, and the views and interpretations of people who have devoted themselves to pursuits other than investing.  My goal is to share some of the insights I have gained from working within the business for so long and to highlight some of the practices that can work against investors’ interests.

The first topic in this edition concerns fiduciary duty, which is the responsibility to act in a client’s best interest.  Unfortunately for investors, there is an incredibly wide array of interpretations of fiduciary duty and worse, the standard does not apply in any legal sense to vast swaths of the business.

The second topic involves some of the key elements of Arete’s approach to stock research.  When I talk to people about stocks what strikes me more than anything else are the number of assumptions and mental models people use that I think are completely inappropriate for long-term investment success.  This is my effort to help bridge the gap.

I always enjoy talking about the money management business in general and about Arete in particular.  If you are going to be in downtown Baltimore, please let me know, I’d love to get together.  I enjoy sharing the ideas I have and it also helps me to hear what investors are most concerned about.

Thanks and take care!

David Robertson, CFA
CEO, Portfolio Manager

Insights


You say tomato . . .

Variety is the spice of life and we enjoy it as much as anyone.  In fact, if it were not for differences in opinion, our job of picking stocks would not exist — a point that is never lost on us.  Different people have different perspectives and viewpoints and that is part of what makes life so colorful.

Sometimes though, we say the same thing, but mean something very, very different.  Often this happens when people have different value systems or mental models from which they make sense of how the world works.  This phenomenon is especially evident in the investment management business and its importance is often underappreciated.

How many times have we heard, “We are here to serve our clients”?  What does it really mean?  It clearly means something different for Goldman Sachs than it does for some of their CDO (collateralized debt obligation) clients.  One of the ways variety gets manifested in investment services is through the vast array of approaches and attitudes toward client relationships. 

Many of the standards for service in the investment industry are prescribed at least in part by regulation.  Registered representatives (brokers), for example, are held only to the standard of selling securities that are “suitable” for their clients.  Once suitability is determined, the operative standard is caveat emptor (buyer beware).

The suitability standard is far different, however, and considerably lower, than the standard of serving in a client’s best interest.  Indeed, only registered investment advisors (RIAs) are formally bound to the standard of fiduciary duty.  Although many other industry players may perform similar functions, they are not held to the same service standards.  We believe this is a critically underappreciated aspect of the business. 

In order to capture the difference in standards, imagine if brokers had to issue a disclaimer before engaging in any stock transaction.  The warning might read something like: “I have no obligation to act in your best interest; my obligation is to serve my employer.  I am not required to have formal training in investments.  I get paid on the basis of initiating transactions which creates an incentive to maximize transactions and may very well serve to reduce your wealth.” 

All of this is not to say there aren’t very good brokers with a great deal of integrity — clearly there are.  Instead, it is intended to delineate exactly where professional obligations end, and trust needs to take over.

That there are differences in standards is only part of the problem.  Quite clearly there is also enormous “variety” within the RIA community regarding what constitutes fiduciary duty.

The concept of fiduciary duty is normally applied to investment securities and portfolio construction, but it is hard to understand why it should stop there.  Importantly, virtually all asset managers charge on the basis of assets under management which, by definition, detracts from returns.  As such, it is difficult for us to see how charging excessive fees can fulfill an obligation to act in a client’s best interest.    

Some recent research into industry compensation reveals the magnitude of this problem.  John Plender recently reported in the Financial Times: “Academics Thomas Phillipon and Ariell Reshef estimate that 30 – 50 per cent of the wage differential between the US financial sector and the rest of the private sector comes from rent-seeking — the economist’s euphemism for ripping off customers in opaque and inadequately competitive markets.”

Gillian Tett and Kate Burgess, also reporting for the Financial Times, capture some of the mechanisms at work in the industry: “While in much of the western business world the trend has been to remove middlemen, investing has gone in the opposite direction.  Not only did the sector expand at a startling rate in recent decades but the ‘investment chain’ that links those supplying capital with the people who ultimately use it has become fiendishly complex, riddled with agents creaming off fees along the way.”

To us, the standard of acting in the best interest of our clients is not hard to articulate.  Indeed, is not really any different than: “Do unto others as you would have them do unto you.”  By this standard, we believe reasonable fees are an essential component of fiduciary duty.  We don’t want our investment returns slashed every year by excessive fees so we don’t inflict them on our clients either.

Much of this discussion of service standards may be considered little more than a frivolous nicety.  We argue that a service standard can represent far more than a standard for interaction, it can represent a critical component of risk management. 

We think of the nature of client/vendor relationships as being a bit like insurance.  When times are good, it is easy to rationalize skipping premiums on an insurance policy by working with people you may not completely trust.  When times are tough though, the lack of an insurance policy, in the form of an advisor truly acting in your best interest, can be potentially devastating.  This holds true for individuals and institutions alike.

In conclusion then, the same expression can mean very different things to different people.  Within the investment management business, serving clients can mean very different things.  While the phrase caveat emptor has historically guided much of the business, there seems to be an opportunity for much of the business to graduate to a higher standard.  Arete was built on the principle of applying a higher standard to fiduciary duty and we look forward to showing you exactly what we mean by it.

Insider’s View

As in any business, the more familiar one gets with underlying structures, relationships, and incentives, the more likely one can identify disparities between common perceptions and underlying reality. 

Our goal in this section is to share our insights into how the investment management business really works.  One way we hope to do this is by wading through the blizzard of information that surrounds the business and distilling the most salient points for investors.  Another is to identify and forewarn investors of some of the business practices in the industry that can work against investors’ objectives.  In both instances, we hope to provide greater clarity.

We discuss these ideas for a couple of reasons.  First, we want to share our knowledge of, and experience in, the money management business to help people better achieve their investment goals.  Second, we do this to help differentiate the value of our services.  We believe the more we can help you understand the underlying reality of the investment management business, the more you will appreciate what we do and why we do it.


When we talk to people about stocks, many often have questions about our process of doing research.  Several have asked us specifically to provide more insight into how we go about selecting stocks so we thought this would be an appropriate place to do exactly that.

First, and importantly, this exercise will not be a tutorial on how to pick stocks.  It is simply not possible to easily and quickly capture all of the education, experience, and insights of a career in the business. 

That said, the exercise need not be mysterious and arcane either.  We are always skeptical of processes or explanations we cannot understand.  We normally find that when explanations are obtuse, they are either intended to mislead, or are reflective of lack of understanding.  Our approach is designed to be clear and understandable.  If it is not, please let us know.

With so many things to talk about, we will begin with a bit of philosophy.  When we consider the nature of stock picking deeply, we believe it is essentially, and in a very general way, an exercise in attaining knowledge.  As such, it makes sense to think about what knowledge is and how people arrive at a state of being knowledgeable. 

The way we illustrate our working model of knowledge attainment is through an analogy to manufacturing.  The model involves three primary components.  The first is data and information which are the “raw materials”.  The second component consists of the models and analytical frameworks which are the fabricated “parts” of knowledge.  The third component is “assembly” which pulls all of the pieces together, connecting them into one cohesive unit.  Combined, we have what we call knowledge.

Applying this model should make it a bit easier to understand what goes into our process for stock research.  We start with gathering information and data on various companies.  We use that information to feed various models and analytical processes in order to generate incremental insights.  We then evaluate multiple hypotheses and potential future scenarios, and confirm and disconfirm evidence for each.  When we pull everything together, it constitutes our “knowledge” of an investment and can be compared to what the market is discounting.

This model of knowledge attainment sheds light on two aspects of our research process.  First, the model is a very general one that is by no means proprietary to stock selection or money management.  In an important sense, what we do is no mystery; it is what any professionals do in their areas of expertise.  As a result, most anyone should be able to apply the model to their area of expertise and quickly identify where they have advantages over less experienced players. 

The second aspect highlighted by the model is the chain of value in the research process.  We often get asked about our data sources, screening methodologies, and so on.  As the model suggests, however, these items are raw materials, are normally commoditized, and as such, do not contribute much value to the end product. 

The most valuable components of Arete’s research process involve the fabricated “parts” and “assembly”.  Specifically, our research efforts focus on uniquely adapting various models and synthesizing insights gained from various thought experiments. 

While this is a very high level view of the research process, hopefully it lays a strong foundation for understanding how we look at stocks.  In future issues we will delve into more detail about the components of the process.

Welcome

There is no doubt that there are some significant challenges to the economy and markets in today’s environment.  While some of the conditions undoubtedly make life more difficult, I can’t help but to be fascinated by the constant change and complexity of the issues and opportunities.  

In this edition, I am going to discuss a couple of different challenges.  One is the challenge to the U.S. economy.  Clearly high unemployment and fiscal deficits are big problems that need to be addressed.  Despite this challenge, we see silver linings in the process. 

The second is a challenge within the money management business.  Because so much of the nature of the business is intangible, it is difficult to judge quality.  As a result, many investors use size as a proxy for determining “quality” of a money manager.  If we have learned anything over the last two years though, it is that size can just as easily impinge upon quality as enhance it.  In fact, I founded Arete two years ago, with the mission of delivering functional excellence in money management — because I thought a small, independent firm had structural advantages in delivering active investment performance and high fiduciary standards.

I always enjoy talking about the money management business in general and about Arete in particular.  If you are going to be in downtown Baltimore, please let me know, I’d love to get together.  I enjoy sharing the ideas I have to try to make things better and it also helps me to hear what investors are most concerned about.

Thanks and take care!

David Robertson, CFA
CEO, Portfolio Manager

Insights

Citizens from all walks of life are becoming extremely concerned about the multitude of challenges facing this country.  Huge fiscal deficits, high and enduring unemployment, and potential for significantly higher inflation are all very serious problems.  It is especially troubling that wherever we turn, we see institutions that are woefully deficient in constructively addressing such problems.

While we do not dispute the severity of such issues, we are not fatalistic about them either.  This position was brought into clear relief in a presentation we attended a couple of weeks ago in which the speaker asked the audience two questions.  The first was, “Are you optimistic?”  The second was, “Do you expect your children will be better off than you are?”  Most of the audience, including us, responded positively to the first question and negatively to the second.

This struck us immediately as interesting because at the very least, our responses were superficially inconsistent.  At worst, they were logically inconsistent.  So the questions forced us to better-understand, or at least to better-articulate, the rationale behind the responses.

Let’s start with the second question first.  Why do we believe that our children will not be better off than we are?  We see all of the issues listed above as being part of a bigger problem: This country has been spending more than it takes in for a long time.  The problem, however, is more onerous than this because it does not account for the liabilities of Medicare and Social Security.  As a country, we have been mortgaging our future.  In order to restore balance, we will need to redefine the social contract and the costs will necessarily fall on future generations.

Nobody likes picking up the tab for someone else which is why we believe our children will not be better off than we are.  Importantly, however, we don’t believe they will be much worse off either.  We actually see several reasons to be optimistic about the future.

First and foremost, we see the populist outrage towards unemployment and the deficit as providing important impetus to finally address problems that have been lurking for many years.  The biggest of these problems is the cost of large entitlement programs such as Medicare and Social Security.  We know the dollar amount of promised benefits of these programs will eventually dwarf our ability to pay for them. 

While the annual fiscal deficit is just the tip of this big iceberg, at least people see it now and know that it represents a big risk to the future of this country.  We believe this recognition is an important step in the right direction.

We don’t have any delusions that the political path to fiscal prudence will be an easy one.  We don’t view the problem as being intractable, however.  We see it more as an issue of proper communication and education. 

For example, A recent billboard stating, “Keep the government’s hands off my Medicare!” we think captures some of the popular misconceptions well.  The link between benefits and costs is apparently not clear to everyone.  At the end of the day, however, we believe most parents want a better world for their children and will make the appropriate tradeoffs and sacrifices to accomplish that end. 

What do investment prospects look like for young families?  Again, we have several reasons for optimism.  For those who are just entering the wealth creation phases of their lives, the first investment is often a home.  With low mortgage rates, excess supply of homes, and a significant retrenchment in home prices, this is a great time to be looking for a home. 

The opportunities for other investments are also attractive.  Having just emerged from the worst ten year stock performance on record, we are at a much better starting point for those who are beginning to invest with a large allocation to stocks.  Conversely, the outlook for fixed income investments is fraught with risk.  With interest rates at rock bottom, they will almost certainly rise higher over the next several years.  When they do, returns from fixed income vehicles will suffer.

In conclusion, we do believe there are very serious fiscal and economic challenges that need to be addressed.  These problems are likely to make it difficult for “our children” to be better off than we are.  Nonetheless, we see many reasons to be optimistic.  We believe widespread acknowledgement of fiscal deficits increases the chances of a solution.    In addition, the opportunities for young families to invest in homes and stocks are actually extremely good.  While there are concerns and uncertainty, we may very well look back ten years from now and marvel at the historic opportunity.

Insider’s View

As in any business, the more familiar one gets with underlying structures, relationships, and incentives, the more likely one can identify disparities between common perceptions and underlying reality. 

Our goal in this section is to share our insights into how the investment management business really works.  One way we hope to do this is by wading through the blizzard of information that surrounds the business and distilling the most salient points for investors.  Another is to identify and forewarn investors of some of the business practices in the industry that can work against investors’ objectives.  In both instances, we hope to provide greater clarity.

We discuss these ideas for a couple of reasons.  First, we want to share our knowledge of, and experience in, the money management business to help people better achieve their investment goals.  Second, we do this to help differentiate the value of our services.  We believe the more we can help you understand the underlying reality of the investment management business, the more you will appreciate what we do and why we do it.

Arete Asset Management was founded with the mission of delivering “functional excellence in money management.”  Indeed Arete’s creation arose from two related premises.  One is that while there are thousands upon thousands of money managers, there are too few exceptional ones.  The second is that there will always be demand for excess performance (alpha).  In this section, we describe how we view “quality” and in doing so, will clarify the logic for how we pursue business.

One of the seminal works of research in finance is called “The Limits of Arbitrage” by Andrei Shleifer and Robert W. Vishny.  For some background, arbitrage is not some obscure or trivial exercise.  Instead, at its essence, arbitrage is the effort to find disparities between value and price.  Colloquially, this essentially means “buy low and sell high.”  Any effort to “outperform” the market through active management is an exercise in arbitrage.

As the world of investing has become democratized over the last thirty to forty years, an important change has occurred.  Now, “Arbitrage is conducted by a relatively small number of highly specialized investors who take large positions using other people’s money.”  This relationship between investors, who act as principals, and money managers, who act as agents, has important implications for asset pricing. 

A key insight of the report is that the arbitrage exercise can become ineffective in “extreme circumstances when prices diverge far from fundamental values.”  The explanation is that some nervous investors can pull capital out of money managers at the worst possible time — the time of greatest opportunity for the money manager.  In doing so, investors themselves actually limit the ability of their money managers to outperform. 

An excellent example of the limits of arbitrage occurs with mutual funds.  When market prices fall, and the gaps between prices and fundamental values widen, some investors get nervous and withdraw funds.  Withdrawal of funds forces the mutual fund manager to sell stocks at exactly the same time that manager is finding the greatest opportunities to buy.  Research points to the fact that such fickle fund flows impair a manager’s ability to perform, regardless of that individual’s level of talent.   

Given this insight, it is clearly incumbent upon a money manager set on delivering outperformance, to find client investors who are committed to riding out market volatility.  Such “patient” capital allows the manager to leverage his or her skills of effectively exploiting arbitrage opportunities.  In short, there is a distinct benefit to the money manager for having client investors with long time horizons.

This is not a one-way street, however, because there is also a distinct benefit to client investors for being patient.  That benefit comes in the form of enhanced performance opportunities!  In other words, superior performance derives at least partly from a symbiotic relationship between manager and client.  In a very important way, quality in money management is a function of the nature of that relationship.

We find it worth noting that one of the most successful investors of our age, Warren Buffett, does not run a money management firm.  He has insulated himself from the vagaries of nervous client fund flows and instead substituted the regular inflows of insurance premiums.  As a result, he can pursue arbitrage opportunities without undo constraint.

Since an important part of the proposition of delivering investment quality is finding the right clients, Arete places a great deal of emphasis on this.  We very much believe that our ability to leverage arbitrage opportunities and deliver performance is contingent upon it.    

In doing so, we consciously resist the temptation to grow for the sake of growing, to take in whatever assets we can.  Based upon our experiences, when small money managers overreach to gather assets, principles of stewardship are almost always compromised.  For one, weak and/or inappropriate relationships can hinder performance through the limits of arbitrage.  In addition, once a firm prioritizes asset gathering over performance, it is almost impossible to go back — the culture is set. 

Of course this presents a paradox rich in irony.  Our mission of delivering quality investment management services largely prescribes deliberate and measured business development.  Yet many investors use size as a proxy for quality, or at very least as a minimum standard of entry.  Unfortunately, we believe this state of affairs often leaves both parties worse off.      

We and plenty of other emerging managers start our businesses because we feel strongly about delivering superior investment value to an undersupplied market.  Arete specifically was built on the principles of sharing our investment skills and providing exceptionally high standards of stewardship. To any investors who complain of high fees, mediocre returns, and/or unreasonable terms from their money managers, we would very much enjoy having a conversation.

Welcome

I chose money management as a career over twenty years ago because I enjoyed the intellectual challenge of investing and because it gave me the opportunity to provide an important and valuable service.  A big part of the challenge is sorting through all of the news and data to develop meaningful insights.  

In this edition, I am going to discuss two topics that I think are timely and useful.  The first is an evaluation of emerging markets and the implications for portfolio construction.  The second article highlights research from the field of behavioral investing and analyzes the implications for trading. 

I always enjoy talking about the money management business in general and about Arete in particular.  If you are going to be in downtown Baltimore, please let me know, I’d love to get together. 

Thanks and take care!

David Robertson, CFA
CEO, Portfolio Manager

Insights

We regularly assess the business landscape for money management as part of the process of reviewing and updating our business plan.  In the course of doing this over the past several quarters, one of the developments we have been watching closely is the massive interest (and fund flows) in emerging markets. 

Our interest is twofold.  From an investment standpoint, our US stock strategy may be competitively disadvantaged if the best investments are in emerging markets.  From a business standpoint, the interest in emerging markets also represents a potential risk: Fewer investment opportunities in US capital markets would portend lower demand for our services.  For the purposes of this discussion, we will focus on longer-term fundamental factors and not on current aspects of the “carry trade”.

Interest in emerging markets is being driven by growth opportunities which are hard to deny.  Many of the emerging economies are reaching levels of income which provide for discretionary spending.  When this happens, cultural mores can change fairly rapidly to embrace values favoring education and reduced fertility.  This is the same phenomenon experienced during the Industrial Revolution in the UK and US which significantly enhanced productivity and drove growth. 

Growth in emerging economies is also being assisted in many cases by favorable demographic trends.  Many emerging economies are experiencing their own versions of “Baby Booms” in which unusually large chunks of the population are reaching the stage of their lives during which they are most productive economically.  Such populations enjoy the benefits of rapidly increasing income but are not yet threatened with the cost burdens of large elderly populations. 

While the case for emerging economies is strong, the case for emerging markets is not so simple.  This distinction is under-appreciated. 

In fact, the deeper we dig into emerging markets, the more we see evidence which gives us concern.  John Plender did an excellent job of indentifying important issues in his recent Financial Times article, “Shift of economic power to the East is a complex phenomenon.”  While his analysis focuses on China, the lessons are broadly applicable to emerging markets.

Plender reports, “For one, many valuations are extremely high.  The Shanghai Composite, for example, reached a price/book valuation of seven times last year at its peak.  For perspective, that compares to a five times price/book valuation of the Japanese market at its peak in 1989.” 

Valuation is not the only weakness in the case for emerging markets, however.  Plender goes on to review capital allocation in China.  In particular, he noted that as of mid-September, the Shanghai Composite produced a compounded annual return of about nine percent over the past fifteen years.  While such returns are not poor, they are meager relative to the fifteen percent run rate in nominal GDP growth, and come with a staggering degree of volatility. 

In short, there is a poor connection between economic growth and market returns.  Importantly, the disparity between growth and returns is evidence of poor allocation of capital.  Poor allocation mechanisms serve as a tourniquet by inhibiting the flow of capital to the most productive projects.   In addition, the disparity between growth and returns highlights the importance of market structures themselves which can present significant risks to investors in developing countries.   

Plender notes that in China, “The family model predominates, which means that in the quoted sector there is a perennial conflict of interest with outside shareholders, who are often short-changed as a result of opaque related party transactions.  Accountability is further muddied by the presence of communist party officials who can call the shots from below board level.” 

Corroborating the risks in the Chinese markets, The Economist also recently noted that Chinese leaders “remain preoccupied by simmering discontent at home: there are tens of thousands of protests each year.  For all the economic progress, all sorts of tensions—social, cultural, demographic, even religious—haunt the regime and help explain why it resorts to nationalism so often.”

To sum up, we have a difficult time justifying such high levels of interest in emerging markets per se.  Being wary of the risks of emerging markets and yet appreciating the growth opportunities, we have tried to find a better way.  That way involves investing in US stocks that have economic exposure to emerging countries.

Our ultimate goal, after all, is to find attractive investment opportunities, not to chase fads.  By investing in US stocks with significant revenue and cash flow exposure to growth opportunities in emerging economies, we largely get the best of both worlds.  We get stocks in a very transparent and liquid capital market and companies that have significant growth opportunities.

Our last words on emerging markets are to suggest it is far too early to count out the US market as an attractive place to invest.  In fact, one of the great strengths of the US market over time has been its powerful capacity to adapt to changing conditions through the process of creative destruction.  While overall market growth is likely to be relatively modest, we believe the process of change and adaptation will create terrific opportunities right here at home.  More on this in our next issue!

Insider’s View

As in any business, the more familiar one gets with the underlying structures, relationships, and incentives at work, the more often one can see disparities between the widespread perception of the business and the underlying reality of the business. 

Our goal in this section is to share our insights into how the investment management business really works.  One way we hope to do this is by wading through the blizzard of information that surrounds the business and distilling the most salient points for investors.  Another is to identify and forewarn investors of some of the business practices in the industry that can work against investors’ objectives.  In both instances, we hope to provide greater clarity.

We discuss these ideas for a couple of reasons.  First, we want to share our knowledge and experience in the business to help people better achieve their investment goals.  Second, we do this partly to help differentiate the value of our services.  We believe the more we can help you understand the underlying reality of the investment management business, the more you will appreciate what we do and why we do it.

An article in the September/October 2009 edition of the CFA Magazine entitled “Effectiveness and Inefficiency” by Stephen Mauzy provides an excellent example of such useful insights into the market.  The article addresses the increase in market liquidity over time, but in doing so also provides useful lessons from the field of behavioral investing. 

Mauzy notes that for most of the long history of the US stock market, disproportionately high profits for brokerage firms were virtually assured through the payment mechanism of fixed commissions. The Securities Act Amendments of 1975 ended the practice and allowed for the emergence of discount brokers.  Mauzy quantifies the impact: Within four years of the Act’s passage, commissions fell between 31 and 47 percent.

Commissions have continued to fall since then as have costs for communications and information.  Quite arguably, the progressive decline in transaction and information costs has leveled the playing field of investing by making it far more accessible.

But has it?  Mauzy describes the work of two prominent researchers in behavioral finance, Brad Barber and Terrance Odean.  They analyzed a group of 1,607 investors who switched from phone-based trading to online trading in the 1990s.

With all the benefits of lower costs and faster execution of online trading, these investors actually performed far worse on average than they had when they relied on placing trades by phone.  Specifically, with phone-based trading, the group beat the market by over two percent per year.  After switching online however, the group underperformed the market by more than three percent per year.

The important insight illustrated by this study is that improved access to markets and information triggers a slew of wealth reducing behaviors.  Barber and Odean list “overconfidence, augmented by self-attribution bias and the illusions of knowledge and control” as the primary culprits.  In other words, it is very easy to believe that one’s trading successes are due to ability rather than luck.  When this happens, it is a short step to a vicious cycle of wealth reduction through excessive trading.

This research may also help explain why we continue to find very attractive investment ideas.  After all, we had expected the markets to become ever-more efficient as the costs of transactions and information came down.  As a result, we also fully expected to see the activity of picking stocks get progressively more difficult over time.  Over the last few years, however, we have had to seriously consider the possibility that improved market access is not increasing efficiency at all.  Rather, perhaps, improved market access is luring progressively more people into the market who fall prey to their own wealth reducing behaviors—to the benefit of more disciplined investors.