July 2016 IssueLong scroll reading

The Black Swan of Brexit

By Edward A. Studzinski

“A bank is a place where they lend you an umbrella in fair weather and ask for it back when it starts to rain.”

Robert Frost

By Edward Studzinski

The title of this month’s piece probably leads one to expect that I will be writing a review of a circa-1930’s costume drama film, set in either 15th century England or France, starring Tyrone Power, etc, etc. Sadly, the time is today. And while many of the players act like fictional characters in terms of temperament and self-interest, unfortunately they are not.

I expect many of my colleagues, especially David, will have a lot more to say about BREXIT than I, but I do think the matter of it as a black swan event is critical. In recent years, many have thought about the United Kingdom as one country, especially after the Scottish secession vote was defeated, without realizing that economically it was many. You have the city state of London and southeastern England, an area that rivals Renaissance Florence as a center of commerce, trade, wealth, culture, and the arts. And then we have the rest of England, which includes the southwest as well as the impoverished former industrial north of Manchester and Yorkshire, an area of high unemployment and rather daunting poverty. Similar segmentation plays out in both Northern Ireland and Scotland. So, the surprise is not that 52% of the population, in a 70% plus voter turnout voted to leave the EU, but rather that the politicians and pollsters got it so wrong.

At this juncture I will spare you the history lesson, but suggest that some digging, especially with attention to The Hundred Years War, will give you a greater appreciation of the back and forth between England and the Continent over a thousand years. And for those who keep making a comparison between the events of today, especially the rise of economic nationalism, and the events of the 1930’s, I will suggest that a more apt comparison is the 15th and 16th centuries, where you had the continuing conflicts between England and France, France and Burgundy, and the economic rivalries of the Italian city states of Florence, Genoa, and Venice. You also had the fall of Constantinople and then Trebizond marking the end of the Byzantine Empire concurrent with the rise of the Ottoman Turks and their empire. And while politics and religion were given lip service as to the primacy of place, the real drivers of events were economics, trade, and the greed for greater personal wealth.

So what investment conclusions can one draw from BREXIT? It is far too soon to tell. Obviously there is and will continue to be a ripple effect, which has already begun in terms of increased market volatility and dislocation. There will be winners and losers, in terms of economies and businesses. At the same time, knee-jerk reactions, either to sell investments or make new investments, are to be avoided. Those who liquidated investments in the first days of a global sell-off have probably realized losses that would not have been losses had they waited a few days longer. Those who ran in and purchased things such as European banks (thought to be undervalued before the BREXIT results) find that that they are still cheap and may become even cheaper. Over the last several months it had become clear that a number of large European banks were going to need additional help from their central bank counterparts. We see then the announcement in the last few days that one of the greatest potential sources of systemic risk to the financial system is Deutsche Bank.

In terms of real assets such as property and commodities, the fog of volatility is even thicker. I have a friend who is in the process of relocating from the UK to Switzerland, an unwinding that has been going on since the beginning of the year. The last piece was to be the sale of a home in London. The higher- end London market had already been somewhat toppy this year, with slowing sales. So, the process was dragging. This week she told me that as a result of last week’s vote, the market price that she had been expecting has dropped by 25%. In terms of commercial real estate, the short-term dislocations should be equally as great. London may appear to be a loser and locations such as Dublin, winners. Alternatively, if the British find their footing and resume being a trading and finance center for Africa and Asia, the property dislocations may be short-lived. At this point no one knows. And once again, investor time horizons matter.

A 25% move in real estate prices in one week is huge, and not easily recovered. Similarly, we saw a huge move in currencies last week, in particular the British pound sterling, by what, 15%, in a very short period? In markets which are zero sum events (for a winner there has to be a loser), we should be looking for some failures or liquidations to be announced in coming days.

And Now For a Word From …..

This brings me to a thought which will surprise many of you, given my previously expressed preferences for low cost, index products for most fund investors. This is almost the ideal environment for the active, long-term oriented value manager. The issue becomes finding that active manager who will put your interests first, above that of career and firm.

At the beginning of June, we were seeing active managers’ performance trailing the index funds (again). A friend related to me a conversation he had had with the director of equity research at an investment management firm that was seeing consistent outflows because of index-lagging performance for the year-to-date, one year, and three year periods (not surprising as most investment and financial consultants have a much shorter investment time-horizon than the one they advise their clients to have). This individual told him that even if the outflows continued and the assets under management dropped to X billions of dollars, he would not be concerned as there would be “more than enough money to go around.” So recognize the priorities here, which were on self-interest.

This is the humorous aspect of seeing presentations from investment firms about eating their own cooking, when the true focus is upon how much can be taken out of the business. For those who think these are random situations rather than episodic, I commend you to an article entitled “For the Love of Money” by Sam Polk which appears in the Sunday, January 19, 2014 Sunday Review section of the Sunday New York Times. The piece discusses the concept of “money addiction” and starts with this sentence, “In my last year on Wall Street my bonus was $3.6 million and I was angry because it wasn’t big enough.”

Think about it. The compensation of a Fortune 100 CEO is disclosed. All-in someone may get a combination of salary, bonus, benefits, and option/stock compensation tied to profitability that may come to perhaps $20 million dollars a year. This is a business with billions of dollars in revenue and profits, thousands of employees, and its performance can have a major impact on the national and global economies. Contrast that with the fund manager whose compensation all-in, for managing $40 billion of assets is $30 million dollars a year, she or he has perhaps forty employees and an economic footprint that is far less. And of course, the $30 million dollars a year is part of a shell-game that is played so that trustees of fund organizations see perhaps a $5 million dollar compensation number for the manager, with other amounts categorized as “ownership interest in the firm” or “long-term compensation pool” etc., etc. But wait, the firm is a wholly-owned subsidiary of an asset-gathering fund company? And people are surprised by how much support politicians like Sanders and Warren have garnered?

There is another game going on here as well, and that is on the parent side of such organizations.

I recently had a conversation with someone at an asset-gathering firm where we talked about the dislocations and shut-downs in the hedge fund and mutual fund industry. This person said to me, look, it is all about leveraging our distribution platform to gather assets. If the assets under management at a subsidiary don’t grow over a five to ten year period, we are going to either offer to sell it back to the subsidiary managers or shut it down. We are not in business to not make money for our shareholders.

I related this conversation to a West Coast-based fund manager who said to me, this explains why a friend of mine at another firm was faced with the choice of mortgaging his home and signing away his life. He was presented with the choice of repurchasing his firm at the price dictated by the parent or being shut-down. Depending on the state where you are doing business, you may face rather dire choices. California of course, has made non-compete agreements illegal. Not so, New York and other jurisdictions.

This brings me to my final point this month. There is a storm brewing that will sweep over the mutual fund business as we know it. The proposed rules from the Department of Labor which will make the financial advisors, the platform companies, and the funds fiduciaries will effect drastic change. On its face, the idea that an investment should be suitable for those purchasing it and the fees disclosed for that investment would appear to make sense. And yet the rules are being fought tooth and nail by the industry.

Have you ever wondered about the economics of purchasing funds through a discount brokerage account where there is a no-transaction fee fund supermarket? Who gets paid and how? Are we talking about billions of dollars here in profits to the discount brokers? Are we talking about the ability to gather assets in funds that would not be able to so do otherwise? What do those 12(b)1 distribution fees you see in the prospectus for distribution really amount to over time? How do they impact the long-term returns on your fund investment? This is the tsunami that is coming.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. Until January of 2012, he was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the eleven plus years that he was in that role, the fund increased more than 35 times in size. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the aerospace & defense, financial services, and spirits & tobacco industries, having followed and owned companies as diverse as Alliant Techsystems, Catellus Development, GATX, General Dynamics, InBev, Kirby, Legacy Hotels, L-3, Nestle, Partner Re, Philip Morris International, Progressive Insurance, Rockwell Collins, Safeco Insurance, Teledyne, Textron, and UST. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing from Northwestern University. A Chartered Financial Analyst, Ed belongs to the Investment Analyst Societies of both Boston and Chicago. He is admitted to the Bar in Illinois, the District of Columbia, and North Carolina.