| Arete Quarterly Q310 |
Welcome
Since it was founded, Arete has considered its ability to apply lessons learned in the business of researching and analyzing stocks to the business of investment management as a skill that was unique to most of the industry. To us, it just seemed to make sense that the trials and tribulations and best practices of other industries could be used to improve one’s own. We always considered it one manifestation of “fresh thinking” that we try to apply to everything we do.
This perspective was cast into a new and more revealing light during a presentation by Michael Mauboussin at a recent Baltimore CFA Society luncheon. In that presentation, Mauboussin discussed his most recent book, Think Twice, which highlights the many ways in which decisions can go wrong and how to avoid them.
One of the ways decisions can go wrong is to focus inordinately on the “inside view.” According to Mauboussin, “The inside view considers a problem by focusing on the specific task and by using information that is close at hand and makes predictions based on that narrow and unique set of inputs.” We have all seen plenty of examples of this. It usually involves something like looking at last year’s growth rate and applying the same rate to the upcoming year. Convenient? Yes. Analytically rigorous? No.
Mauboussin argues that a useful complement to the decision making process is to ask “if there are similar situations that can provide a statistical basis for making a decision.” In other words, are there analogies to other industries or other types of situations that can provide useful context? He calls this the “outside view.”
In applying Mauboussin’s lessons to the real world, some of our favorite examples of the two views come from the money management industry itself. For instance, let’s consider the profitability of the money management business. A report by McKinsey & Company entitled, The Asset Management Industry in 2010, reports, “Year after year, it seems, the industry turns out enviable, solid performance — indeed . . . overall profit margins have held remarkably stable over the past market cycle, just shy of the 30 percent mark.”
How should we assess this performance? Mauboussin’s framework defines two different perspectives from which we can view the industry’s “enviably” high profitability.
The inside view, as is so often the case, is aptly illustrated by industry insiders. When we ask the management teams of large money managers about profitability, we often hear comments like, “We provide incredibly high value to our clients. The value proposition is about far more than investment performance. It is about providing security so they can sleep at night.”
What does the outside view say? According to Jane Marcus and Terry R. Bacon in their 2004 report, Developing Better Asset Management Leadership, “There has not been a profound belief in doing what is right for the client . . . The industry grew out of a Wall Street culture where you manufactured a product and sold it to the client, instead of finding out what the client wanted . . . This has always been a high-margin business, so there was little impetus to analyze profitability, so there has been poor cost and expense control.”
How can there be such a wide gulf between these two views? Upton Sinclair once remarked, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” Is this a possible explanation? Absolutely. Is it likely? We believe so.
We also believe this explains why Arete’s practice of “fresh thinking” is unique to the industry. Not only is intellectual honesty is essential for us in making good investment decisions, it is also crucial for accurately assessing our value proposition to investors.
Marcus and Bacon make quite clear that one of the most important themes from their study was “the importance of developing more effective leadership in the industry.” Alas, Mauboussin’s concluding remark speaks volumes about the state of the industry: “Everyone talks about how important it [decision making] is,” he says, “but they don’t spend time on it. Leadership is incredibly important.” We couldn’t agree more.
Since it was founded, Arete has considered its ability to apply lessons learned in the business of researching and analyzing stocks to the business of investment management as a skill that was unique to most of the industry. To us, it just seemed to make sense that the trials and tribulations and best practices of other industries could be used to improve one’s own. We always considered it one manifestation of “fresh thinking” that we try to apply to everything we do.
This perspective was cast into a new and more revealing light during a presentation by Michael Mauboussin at a recent Baltimore CFA Society luncheon. In that presentation, Mauboussin discussed his most recent book, Think Twice, which highlights the many ways in which decisions can go wrong and how to avoid them.
One of the ways decisions can go wrong is to focus inordinately on the “inside view.” According to Mauboussin, “The inside view considers a problem by focusing on the specific task and by using information that is close at hand and makes predictions based on that narrow and unique set of inputs.” We have all seen plenty of examples of this. It usually involves something like looking at last year’s growth rate and applying the same rate to the upcoming year. Convenient? Yes. Analytically rigorous? No.
Mauboussin argues that a useful complement to the decision making process is to ask “if there are similar situations that can provide a statistical basis for making a decision.” In other words, are there analogies to other industries or other types of situations that can provide useful context? He calls this the “outside view.”
In applying Mauboussin’s lessons to the real world, some of our favorite examples of the two views come from the money management industry itself. For instance, let’s consider the profitability of the money management business. A report by McKinsey & Company entitled, The Asset Management Industry in 2010, reports, “Year after year, it seems, the industry turns out enviable, solid performance — indeed . . . overall profit margins have held remarkably stable over the past market cycle, just shy of the 30 percent mark.”
How should we assess this performance? Mauboussin’s framework defines two different perspectives from which we can view the industry’s “enviably” high profitability.
The inside view, as is so often the case, is aptly illustrated by industry insiders. When we ask the management teams of large money managers about profitability, we often hear comments like, “We provide incredibly high value to our clients. The value proposition is about far more than investment performance. It is about providing security so they can sleep at night.”
What does the outside view say? According to Jane Marcus and Terry R. Bacon in their 2004 report, Developing Better Asset Management Leadership, “There has not been a profound belief in doing what is right for the client . . . The industry grew out of a Wall Street culture where you manufactured a product and sold it to the client, instead of finding out what the client wanted . . . This has always been a high-margin business, so there was little impetus to analyze profitability, so there has been poor cost and expense control.”
How can there be such a wide gulf between these two views? Upton Sinclair once remarked, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” Is this a possible explanation? Absolutely. Is it likely? We believe so.
We also believe this explains why Arete’s practice of “fresh thinking” is unique to the industry. Not only is intellectual honesty is essential for us in making good investment decisions, it is also crucial for accurately assessing our value proposition to investors.
Marcus and Bacon make quite clear that one of the most important themes from their study was “the importance of developing more effective leadership in the industry.” Alas, Mauboussin’s concluding remark speaks volumes about the state of the industry: “Everyone talks about how important it [decision making] is,” he says, “but they don’t spend time on it. Leadership is incredibly important.” We couldn’t agree more.
Business Update
Several years ago I attended the Baltimore Book Festival in Baltimore’s Mount Vernon neighborhood and had the pleasure of listening to David Simon, creator and producer of the HBO series, The Wire. Not surprising to anyone who has watched the series, Simon’s perspective of inner-city life reflects a compelling mixture of clarity, compassion, and concern. One of his messages that always stuck with me was, “If you don’t do something to make things better, you are complicit in the perpetuation of the problems.”
As a city-dweller, I have taken that message to heart regarding my neighborhood, but found it hard to stop there. I guess I also saw a lot of parallels with the investment industry: There are a lot of problems that make things unfair and unnecessarily dangerous to a lot of people; there is a lot of gaming and misinformation; and, it is often hard to tell the bad guys from the good guys. Even if you try to do the right thing, you may get hurt by the many corrupt forces.
In fact, this view is not so different from what I see and hear from many individual investors. People don’t know what to do, but they strongly suspect the game is rigged against them, and they don’t know who to trust. Increasingly, they are withdrawing money from equity funds and/or hoarding cash for lack of more palatable alternatives.
Longer term, this isn’t good for anybody. Individuals will not meet retirement goals if they do not invest and the investment industry may very well contract if people don’t trust it.
I have tried to make things better, in part, by forming Arete. In doing so I wanted to offer investors a very fair value in contrast to the many overpriced and underperforming products that currently exist.
I have also realized, however, that Arete is but one small voice in a very large and rowdy crowd and as such, has very limited ability to affect public opinion — and ultimately primary demand. As long as the investing public is broadly wary of the entire industry, there is little perceived value in trying to differentiate competent and ethical players from others. Therefore, in my effort to try to make things better, I agreed this summer to lead the Baltimore CFA Society. I view this effort as a common quest with the CFA Institute to help improve the professionalism of, and ultimately restore trust in, the money management industry.
The CFA, for those who are not familiar, stands for chartered financial analyst and is the pre-eminent global professional designation for investment analysis. There are about 100,000 CFAs across 137 societies around the world. The CFA Institute is “dedicated to developing and promoting the highest educational, ethical, and professional standards in the investment industry.” I find it interesting that the core tenets of the CFA, ethics, tenacity, rigor, and analysis were all notable for their absence in the key mishaps leading to the financial meltdown in 2008.
How can CFAs and the CFA Institute make things better? As a stock analyst, I always look for two basic things. One is a solid business that can generate a lot of cash. The other is a management team and Board of Directors that will distribute that cash fairly to shareholders. I think investors want the same thing. They want investments that leave them better off and they want to work with investment professionals who have substantial analytical skills and put the interests of their clients first.
The enormous opportunity I see is that the answer to the wants and needs of the investing public already exists in the form of CFAs. In fact, the CFA Institute’s stated objective is to have “global financial markets that service society’s interests.” I think most investors would be heartened to know that such an organization exists.
The only problem is that the vast majority of investors don’t know the CFA Institute exists and have no idea what the CFA is. It’s hard to make things better by improving credibility when people don’t even know that a source of help exists. I look forward to doing what I can to help raise the profile of both the Baltimore CFA Society and the CFA Institute.
In the meantime, if you have any suggestions for how Arete or the Baltimore CFA Society can more effectively pursue this quest, please let me know. Working together, maybe we can all help to make things a little better.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Several years ago I attended the Baltimore Book Festival in Baltimore’s Mount Vernon neighborhood and had the pleasure of listening to David Simon, creator and producer of the HBO series, The Wire. Not surprising to anyone who has watched the series, Simon’s perspective of inner-city life reflects a compelling mixture of clarity, compassion, and concern. One of his messages that always stuck with me was, “If you don’t do something to make things better, you are complicit in the perpetuation of the problems.”
As a city-dweller, I have taken that message to heart regarding my neighborhood, but found it hard to stop there. I guess I also saw a lot of parallels with the investment industry: There are a lot of problems that make things unfair and unnecessarily dangerous to a lot of people; there is a lot of gaming and misinformation; and, it is often hard to tell the bad guys from the good guys. Even if you try to do the right thing, you may get hurt by the many corrupt forces.
In fact, this view is not so different from what I see and hear from many individual investors. People don’t know what to do, but they strongly suspect the game is rigged against them, and they don’t know who to trust. Increasingly, they are withdrawing money from equity funds and/or hoarding cash for lack of more palatable alternatives.
Longer term, this isn’t good for anybody. Individuals will not meet retirement goals if they do not invest and the investment industry may very well contract if people don’t trust it.
I have tried to make things better, in part, by forming Arete. In doing so I wanted to offer investors a very fair value in contrast to the many overpriced and underperforming products that currently exist.
I have also realized, however, that Arete is but one small voice in a very large and rowdy crowd and as such, has very limited ability to affect public opinion — and ultimately primary demand. As long as the investing public is broadly wary of the entire industry, there is little perceived value in trying to differentiate competent and ethical players from others. Therefore, in my effort to try to make things better, I agreed this summer to lead the Baltimore CFA Society. I view this effort as a common quest with the CFA Institute to help improve the professionalism of, and ultimately restore trust in, the money management industry.
The CFA, for those who are not familiar, stands for chartered financial analyst and is the pre-eminent global professional designation for investment analysis. There are about 100,000 CFAs across 137 societies around the world. The CFA Institute is “dedicated to developing and promoting the highest educational, ethical, and professional standards in the investment industry.” I find it interesting that the core tenets of the CFA, ethics, tenacity, rigor, and analysis were all notable for their absence in the key mishaps leading to the financial meltdown in 2008.
How can CFAs and the CFA Institute make things better? As a stock analyst, I always look for two basic things. One is a solid business that can generate a lot of cash. The other is a management team and Board of Directors that will distribute that cash fairly to shareholders. I think investors want the same thing. They want investments that leave them better off and they want to work with investment professionals who have substantial analytical skills and put the interests of their clients first.
The enormous opportunity I see is that the answer to the wants and needs of the investing public already exists in the form of CFAs. In fact, the CFA Institute’s stated objective is to have “global financial markets that service society’s interests.” I think most investors would be heartened to know that such an organization exists.
The only problem is that the vast majority of investors don’t know the CFA Institute exists and have no idea what the CFA is. It’s hard to make things better by improving credibility when people don’t even know that a source of help exists. I look forward to doing what I can to help raise the profile of both the Baltimore CFA Society and the CFA Institute.
In the meantime, if you have any suggestions for how Arete or the Baltimore CFA Society can more effectively pursue this quest, please let me know. Working together, maybe we can all help to make things a little better.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
Last quarter we talked about the relatively strong performance of higher growth and momentum stocks. While the performance of the third quarter was considerably stronger than that of the second, the overall complexion was similar. The market was still driven by “narratives” which emphasized the risk of deflation short-term, and inflation longer-term. This dynamic drove demand for safe, income generating investments and stocks showing consistent earnings growth in the context of a slow growth environment.
It does not surprise us that stocks are trading the way they are given the ample evidence of weak economic growth and the perils of borrowing too much money. The interesting part is that despite these widely understood challenges, many investors do not seem to appreciate that other investors have exactly the same information. As more and more people do the same things, valuations get stretched beyond reasonable limits, and many of these trades start looking very “crowded.”
In the increasingly mad rush for the same types of assets, some perfectly good ones are being left almost completely unnoticed. One of the very interesting opportunities we are seeing unfold is that for stocks with strong cash flow generation that are either not paying dividends or are paying out only a very small portion of earnings. Without high growth or high cash dividends, they just aren’t “sexy” enough right now. This may be easier for us to see than many others because of the bottom-up nature of our research.
These stocks strike us as enormous opportunities. The market is discounting them as if they were not useful or attractive assets. Yet when we dig into the companies, they seem to be extremely attractive and acting extremely responsibly.
Many, it is true, are correlated with overall economic growth which can very well be expected to be slower than in the past. Nonetheless, many are also extremely profitable and generating a great of cash. It is not hard at all to find companies with sustainable double digit free cash flow yields.
Given the uncertainty of the future, however, these companies are being conservative and allowing substantial cash reserves to accumulate. If and when economic growth prospects emerge, capital can very quickly be deployed to grow business organically. If low growth persists, capital can be deployed to increase cash dividends or share repurchases. This allows for maximum optionality; the companies can wait for greater clarity before dedicating capital. To us it sounds like prudent management. If the market wants to keep making these opportunities available, we are happy to oblige!
Last quarter we talked about the relatively strong performance of higher growth and momentum stocks. While the performance of the third quarter was considerably stronger than that of the second, the overall complexion was similar. The market was still driven by “narratives” which emphasized the risk of deflation short-term, and inflation longer-term. This dynamic drove demand for safe, income generating investments and stocks showing consistent earnings growth in the context of a slow growth environment.
It does not surprise us that stocks are trading the way they are given the ample evidence of weak economic growth and the perils of borrowing too much money. The interesting part is that despite these widely understood challenges, many investors do not seem to appreciate that other investors have exactly the same information. As more and more people do the same things, valuations get stretched beyond reasonable limits, and many of these trades start looking very “crowded.”
In the increasingly mad rush for the same types of assets, some perfectly good ones are being left almost completely unnoticed. One of the very interesting opportunities we are seeing unfold is that for stocks with strong cash flow generation that are either not paying dividends or are paying out only a very small portion of earnings. Without high growth or high cash dividends, they just aren’t “sexy” enough right now. This may be easier for us to see than many others because of the bottom-up nature of our research.
These stocks strike us as enormous opportunities. The market is discounting them as if they were not useful or attractive assets. Yet when we dig into the companies, they seem to be extremely attractive and acting extremely responsibly.
Many, it is true, are correlated with overall economic growth which can very well be expected to be slower than in the past. Nonetheless, many are also extremely profitable and generating a great of cash. It is not hard at all to find companies with sustainable double digit free cash flow yields.
Given the uncertainty of the future, however, these companies are being conservative and allowing substantial cash reserves to accumulate. If and when economic growth prospects emerge, capital can very quickly be deployed to grow business organically. If low growth persists, capital can be deployed to increase cash dividends or share repurchases. This allows for maximum optionality; the companies can wait for greater clarity before dedicating capital. To us it sounds like prudent management. If the market wants to keep making these opportunities available, we are happy to oblige!
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