Author Archives: Edward A. Studzinski

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.

Ruminations at Summer’s End

By Edward A. Studzinski

Silence is the most perfect expression of scorn.

                                 George Bernard Shaw

Book Review

David Snowball recently asked if I would have any interest in reading Joel Tillinghast’s (Fidelity Low-Priced Stock Fund) new book entitled Big Money Thinks Small. While I am usually reluctant to read what often end up being collections of anecdotes about how smart someone was, the fact that it had been published by Columbia Business School Publishing overcame my initial reluctance. Much to my surprise, I enjoyed the book immensely, and found it to be a very thoughtful work. Let me first say that I do not know Mr. Tillinghast, other than by reputation. However, I have served on committees with people who do know Mr. Tillinghast and have worked with him. They are uniform in their praise of him both as an investor and as an individual. He is a true polymath with almost total recall. And unlike many who content themselves with a formulaic approach to investing, e.g. mean reversion, he seeks to understand the quality of a business, the numbers supporting the business, and the character, intelligence, and integrity of management. Two chapters in particular I would recommend to all are “Gamblers, Speculators, and Investors” and the last chapter entitled Continue reading →

For Whom Does the Bell Toll?

By Edward A. Studzinski

In the dawn, although I know

It will grow dark again,

How I hate the coming day.

                        Fujiwara No Michinobu

Buffett’s irreproducible edge

First, some addenda to last month’s comments, as there were a number of readers interested in private equity. One reader, whom I happened to agree with, identified Berkshire Hathaway as a private equity proxy, given that (a) Buffett is dealing with permanent capital with a true long-term time horizon, and (b) he has been clearly disciplined and dedicated to going where opportunities surface that others are inclined or required to ignore. It has actually been quite instructive to watch him complement his major holdings in Berkshire’s insurance businesses as well as the equity investments that he owned pieces of, such as American Express and Coca Cola, with the wholesale acquisition of an Continue reading →

Summer Musings

By Edward A. Studzinski

“Change is the law of life. And those who look only to the past or the present, are certain to miss the future.”

      John Fitzgerald Kennedy. Speech, Frankfurt, 25 June 1963.

The first six months of 2017 are gone, and most global markets have surged during that period. So those like me who thought valuations were starting to look extreme at the beginning of the year, once again cried “wolf” too soon. For those six months, Vanguard’s S&P 500 Admiral Fund achieved a total return of 9.3%, with an expense ratio of four basis points. Many actively managed funds, alas, did not perform quite as well for their investors, although their managers continued to do quite well, purchasing Continue reading →

The Boys of Summer

By Edward A. Studzinski

Everything is on such a clear financial basis in France. It is the simplest country to live in. No one makes things complicated by becoming your friend for any obscure reason. If you want people to like you, you have only to spend a little money.

   ERNEST HEMINGWAY

In recent weeks, a number of articles and books have made their way into print, and they are things worth taking a gander at as one ponders where we are in the economic cycle One of my favorite blogs to read is “The Brooklyn Investor,” which can be found at brooklyninvestor.blogspot.com which is updated intermittently. A recent piece was titled “High Fees” and posted May 19, 2017. The author discusses a Continue reading →

The Fifty Year Reich

By Edward A. Studzinski

 

“It is dangerous to be sincere unless you are also stupid.”

  George Bernard Shaw

Some thirty-odd years after its founding, the transformation of Morningstar is complete. From a firm that got its start providing tools and research to assist the individual investor, we now see a firm that exists to offer tools, support, and research to financial advisors or intermediaries. To a large extent, that evolution was necessary given the changes in the marketplace for mutual funds, as well as the changes in the regulatory environment. And once Morningstar became a public company, it would have been incumbent upon its employees and management to focus on Continue reading →

Nothing Personal, It’s Just Business

By Edward A. Studzinski

“This is the business we’ve chosen. I didn’t ask who gave the order, because it had nothing to do with business.”

Hyman Roth speaking to Michael Corleone in the movie “Godfather II”

Another month has gone by, and the current period of disruption has not only continued, but accelerated in the mutual fund management business. For all but the true believers (or perhaps those holding stock in the publicly-traded fund managers), it should be apparent that we are witnessing not just a cyclical decline, but a secular one.

Let’s start with the settlement between Bill Gross and Continue reading →

Half a league, half a league, half a league onward —–

By Edward A. Studzinski

“Frost on grass: a fleeting form, that is and is not!”

  Zaishiki

This is the time of the month when I am usually wrestling with what to say and trying to avoid repeating myself, which can be pretty difficult after several years of columns. This month, I have something of a surfeit of material, so I will apologize in advance for the rambling.

A few weeks ago, I attended the annual Graham and Dodd Conference at Columbia University’s Graduate School of Business in New York. As always, the speakers were Continue reading →

Survival of the Flushest?

By Edward A. Studzinski

“Cynic, n. A blackguard whose faulty vision sees things as they are, not as they ought to be.”

Ambrose Bierce

A question I have been pondering with increasing frequency is, of the mutual funds around today, how many of them will still be around in ten years? This grew out of a year-end luncheon with a friend of mine who heads up the strategic planning effort for a large financial services firm out of Chicago that has gone global and now has its fingers in many pies. Our discussion started around the problem with Continue reading →

“What Goes Around ……”

By Edward A. Studzinski

Democracy – “The substitution of election by the incompetent many for the appointment of the corrupt few.”

        George Bernard Shaw

So, another calendar year has gone by, and fund managers everywhere are dissecting their relative performance in comparison to some benchmark index. To put things into perspective for a real-world comparison (at least in terms of the performance numbers), the Admiral shares of the Vanguard S&P 500 Index Fund, which charges a five basis point fee, had a one-year Continue reading →

Behind Door Number Two Is?

By Edward A. Studzinski

 

“I and my public understand each other very well: it does not hear what I say, and I don’t say what it wants to hear.”

Karl Kraus

I recently had occasion to read proxy materials for San Juan Basin Royalty Trust. The issue involved an attempt to remove the current trustee, Compass Bank, the successor to TexasBank, which had been acquired by Compass, with Southwest Bank. The story is a recurring one in banking – a smaller local institution gets gobbled up by Continue reading →

Priceless – Worth Absolutely Nothing!

By Edward A. Studzinski

“Under this flabby exterior is an enormous lack of character.”

  Oscar Levant

This has proven a rather difficult time to write something and feel that you are either (a) not repeating things you have said before or (b) speaking with the certainty that you are offering some genuine insight that will prove advantageous to our readers as they pursue their investment programs. For those reasons, I will endeavor to be brief, which will probably result in my being more obscure in my comments than usual. I offer thus a number of random thoughts which should Continue reading →

What Price Integrity?

By Edward A. Studzinski

“Question in a Field” by Louise Bogan

Pasture, stone wall, and steeple,
What most perturbs the mind:
The heart-rending homely people,
Or the horrible beautiful kind?

From: The Maine Poets

 

So we watch now the public flogging of senior officials of Wells Fargo by our esteemed members of Congress, which is not to say that the flogging is Continue reading →

Behind the Curtain

By Edward A. Studzinski

“Moon in a barrel: you never know just when the bottom will fall out.”

 Mabutsu (19th Century Japanese haiku poet)

So, August as usual is the period of the “dog days” of summer, usually a great opportunity to catch up on reading. A site I commend to you for all things investment is Hurricane Capital, recommended to me by my friend Michael Mauboussin, of Credit Suisse. Among other things Michael pointed out that the writer of this blog (from Sweden) had posted all of Michael’s strategy and thought pieces going back for years. A recent one, which I would suggest is worth a read is Continue reading →

Have We Been Here Before?

By Edward A. Studzinski

“The past is never dead. It’s not even past.”

William Faulkner

I recently had coffee with one of my former colleagues in the investment management world. He asked me if our readers understood that, in the world of mutual fund managements, it was all about assets under management and profitability to the various stakeholders in the business. Thoughts about the returns for the investor were generally secondary, or put differently, whether the investors actually got any yachts (or vacations in the Caribbean or second homes on Hilton Head Island) did not matter. Having recently reviewed some posts on our Bulletin Board, I told him that no, many of our readers were still operating under the belief that there was, somewhere in that room full of manure, a pony.

Our desire for hope and change (at least in terms of investment returns) often leads us to ignore the evidence of simple mathematics working against us. Continue 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.

All That Glitters ….

By Edward A. Studzinski

By Edward Studzinski

One should forgive one’s enemies, but not before they are hanged.

Heinrich Heine

So, we are one-third through another year, and things still continue to be not as they should be, at least to the prognosticators of the central banks, the Masters of the Universe on Wall Street, and those who make their livings reporting on same, at Bubblevision Cable and elsewhere. I am less convinced than I used to be that, for media commentators, especially on cable, the correct comparison is to The Gong Show. More often than not, I think a more appropriate comparison is to the skit performed by the late, great, and underappreciated Ernie Kovacs, “The Song of the Nairobi Trio.”

And lest I forget, this is the day after another of Uncle Warren’s Circuses, held in Omaha to capacity crowds. An interesting question there is whether, down the road some fifty years, students of financial and investing history discover after doing the appropriate first order original source research, that what Uncle Warren said he did in terms of his investment research methodology and what he in reality did, were perhaps two different things. Of course, if that were the case, one might wonder how all those who have made almost as good a living selling the teaching of the methodology, either through writing or university programs, failed to observe same before that. But what the heck, in a week where the NY Times prints an article entitled “Obama Lobbies for His Legacy” and the irony is not picked up on, it is a statement of the times.

goldThe best performing asset class in this quarter has been – gold. Actually the best performing asset class has been the gold miners, with silver not too far behind. We have had gold with a mid-teen’s total return. And depending on which previous metals vehicle you have invested in, you may have seen as much as a 60%+ total return (looking at the germane Vanguard fund). Probably the second best area generically has been energy, but again, you had to choose your spots, and also distinguish between levered and unlevered investments, as well as proven reserves versus hopes and prayers.

I think gold is worth commenting on, since it is often reviled as a “barbarous relic.” The usual argument against it that it is just a hunk of something, with a value that goes up and down according to market prices, and it throws off no cash flow.

I think gold is worth commenting on, since it is often reviled as a “barbarous relic.”

That argument changes of course in a world of negative interest rates, with central banks in Europe and one may expect shortly, parts of Asia, penalizing the holding of cash by putting a surcharge on it (the negative rate).

A second argument against it is that is often subject to governmental intervention and political manipulation. A wonderful book that I still recommend, and the subjects of whom I met when I was involved with The Santa Fe Institute in New Mexico, is The Predictors by Thomas A. Bass. A group of physicists used chaos theory in developing a quantitative approach to investing with extensive modeling. One of the comments from that book that I have long remembered is that, as they were going through various asset and commodity classes, doing their research and modeling, they came to the conclusion that they could not apply their approach to gold. Why? Because looking at its history of price movements, they became convinced that the movements reflected almost always at some point, the hand of government intervention. An exercise of interest would be to ponder how, over the last ten years, at various points it had been in the political interests of the United States and/or its allies, that the price of gold in relation to the price of the dollar, and those commodities pegged to it, such as petroleum, had moved in such a fashion that did not make sense in terms of supply and demand, but made perfect sense in terms of economic power and the stability of the dollar. I would suggest, among other things, one follow the cases in London involving the European banks that were involved in price fixing of the gold price in London. I would also suggest following the timetable involving the mandated exit of banks such as J.P. Morgan from commodity trading and warehousing of various commodities.

Exeunt, stage left. New scenario, enter our heroes, the Chinese. Now you have to give China credit, because they really do think in terms of centuries, as opposed to when the next presidential or other election cycle begins in a country like the U.S. Faced with events around 2011 and 2012 that perhaps may have seemed to be more about keeping the price of gold and other financial metrics in synch to not impact the 2012 elections here, they moved on. We of course see that they moved on in a “fool me once fashion.” We now have a Shanghai metals exchange with, as of this May, a gold price fixing twice a day. In fact, I suspect very quickly we will see whole set of unintended consequences. China is the largest miner of gold in the world, and all of its domestic supply each year, stays there. As I have said previously in these columns, China is thought to have the largest gold reserves in the world, at in excess of 30,000 tons. Russia is thought to be second, not close, but not exactly a slouch either.

So, does the U.S. dollar continue as the single reserve currency (fiat only, tied solely to our promise to pay) in the world? Or, at some point, does the Chinese currency become its equal as a reserve currency? What happens to the U.S. economy should that come to pass? Interesting question, is it not? On the one hand, we have the view in the U.S. financial press of instability in the Chinese stock market (at least on the Shanghai stock exchange), with extreme volatility. And on the other hand, we have Chinese companies, with some degree of state involvement or ownership, with the financial resources to acquire or make bids on large pieces of arable land or natural resources companies, in Africa, Australia, and Canada. How do we reconcile these events? Actually, the better question is, do we even try and reconcile these events? If you watch the nightly network news, we are so self-centered upon what is not important or critical to our national survival, that we miss the big picture.

Which brings me to the question most of you are asking at this point – what does he really think about gold? Some years ago, at a Grant’s Interest Rate Observer conference, Seth Klarman was one of the speakers and was asked about gold. And his answer was that, at the price it was at, they wanted to have some representation, not in the physical metal itself, but in some of the gold miners as a call option. It would not be more than 5% of a portfolio so that in the event it proved a mistake, the portfolio would not be hurt too badly (the opposite of a Valeant position). If the price of gold went up accordingly, the mine stocks would perhaps achieve a 5X or 10X return, which would help the overall returns of the portfolio (given the nature of events that would trigger those kinds of price movements). Remember, Klarman above all is focused on preserving capital.

And that is how I pretty much view gold, as I view flood insurance or earthquake insurance. Which, when you study flood insurance contracts you learn does not just cover flooding but also cases of extreme rain where, the house you built on the hill or mountain goes sliding down the hill in a massive mudslide. So when the catastrophic event can be covered for a reasonable price, you cover it (everyone forgets that in southern Illinois we have the New Madrid fault, which the last time it caused a major quake, made recent California or Japanese events seem like minor things). And when the prices to cover those events become extreme, recognizing the extreme overvaluation of the underlying asset, you should reconsider the ownership (something most people with coastal property should start to think about).

Twenty-odd years ago, when I first joined Harris Associates, I was assigned to cover DeBeers, the diamond company, since we were the largest shareholders in North America. I knew nothing about mining, and I knew nothing about diamonds, but I set out to learn. I soon found myself in London and Antwerp studying the businesses and meeting managements and engineers. And one thing I learned about the extractive industries is you have to differentiate the managements. There are some for whom there is always another project to consume capital. You either must expand a mine or find another vein, regardless of what the price of the underlying commodity may be (we see this same tendency with managements in the petroleum business). And there are other managements who understand that if you know the mineral is there sitting in the ground, and you have a pretty good idea of how much of it is there, you can let it sit, assuming a politically and legally stable environment, until the return on invested capital justifies bringing it out. For those who want to develop this theme more, I suggest subscribing to Grant’s Interest Rate Observer and reading not just its current issues but its library of back issues. Just remember to always apply your own circumstances rather than accept what you read or are told.

 The Honorable Thing

By Edward A. Studzinski

“Advertising is the modern substitute for argument; its function is to make the worse appear the better.”

               George Santayana

So we find one chapter at Sequoia Fund coming to a close, and the next one about to begin.  On this subject my colleague David has more to offer. I will limit myself to saying that it was appropriate, and, the right thing to do, for Bob Goldfarb to elect to retire. After all, it happened on his watch. Whether or not he was solely to blame for Valeant, we will leave to the others to sort out in the future. Given the litigation which is sure to follow, there will be more disclosures down the road.

A different question but in line with Mr. Santayana’s observations above, is, do those responsible for portfolio miscues, always do the honorable thing? When one looks at some of the investment debacles in recent years – Fannie and Freddie, Sears, St. Joe, Valeant (and not just at Sequoia), Tyco, and of course, Washington Mutual (a serial mistake by multiple firms)  – have the right people taken responsibility? Or, do the spin doctors and public relations mavens come in to do damage control? Absent litigation and/or whistle blower complaints, one suspects that there are fall guys and girls, and the perpetrators live on for another day. Simply put, it is all about protecting the franchise (or the goose that is laying the golden eggs) on both the sell side and the buy side. Probably the right analogy is the athlete who denies using performance enhancing drugs, protected, until confronted with irrefutable evidence (like pictures and test results).

Lessons Learned

Can the example of the Sequoia Fund be a teaching moment? Yes, painfully. I have long felt that the best way to invest for the long-term was with a concentrated equity portfolio (fewer than twenty securities) and some overweight positions within that concentration. Looking at the impact Sequoia has had on the retirement and pension funds invested in it, I have to revisit that assumption. I still believe that the best way to accumulate personal wealth is to invest for the long-term in a concentrated portfolio. But as one approaches or enters retirement, it would seem the prudent thing to do is to move retirement moneys into a very diverse portfolio or fund.  That way you minimize the damage that a “torpedo” stock such as Valeant can do to one’s retirement investments, and thus to one’s standard of living, while still reaping the greater compounding effects of equities. There will still be of course, market risk. But one wants to lessen the impact of adverse security selection in a limited portfolio. 

Remember, we tend to underestimate our life expectancy in retirement, and thus underweight our equity allocations relative to cash and bonds. And in a period such as we are in, the risk free rate of return from U.S. Treasuries is not 12% or 16% as it was in the early 1980’s (although it is perhaps higher than we think it is). And for that retirement equity position, what are the choices?  Probably the easiest again, is something like the Vanguard Total Stock Market or the Vanguard S&P 500 index funds, with minimal expense ratios. We have been talking about this for some time now, but Sequoia provides a real life example of the adverse possibilities.  And, it is worth noting that almost every concentrated investment fund has underperformed dramatically in recent years (although the reasons may have more to do with too much money chasing too few and the same good ideas). Is it really worth a hundred basis points to pay someone to own Bank of America, Wells Fargo, Microsoft, Johnson & Johnson, Merck, as their top twenty holdings? Take a look sometime at the top twenty holdings of the largest actively managed funds in the respective categories of growth, growth and income, etc., and see what conclusions you draw.

The more difficult issue going forward will be deflation versus inflation. We have been in a deflationary world for some time now. It is increasingly apparent that the global central banks are in the process (desperately one suspects) to reflate their respective economies out of stagnant or no growth. Thus we see a variety of quantitative easing measures which tend to favor investors at the expense of savers. Should they succeed, it is unlikely that the inflation will stop at their targets (2% here), and the next crisis will be one of currency debasement. The more things change.

Gretchen Morgenson, Take Two

As should be obvious by now, I am a fan of Ms. Morgenson’s investigative reporting and her take no prisoners approach. I don’t know her from Adam, and could be standing next to her in the line for a bagel and coffee in New York and would not know it. But, she has a wonderful knack for goring many of the oxen that need to be gored.

In this Sunday’s New York Times Business Section, she raised the question of the effectiveness of share buybacks. Now, the dirty little secret for some time has been that growth of a business is not impacted by share repurchases. Yet, if you listened to many portfolio managers wax poetic about how they only invest with shareholder friendly managements (which in retrospect turn out to have not been not so shareholder friendly after they have been indicted by a grand jury). Share repurchase does increase per share metrics, such as book value and earnings.  While the pie stays the same size, the size of the pieces changes. But often in recent years, one wonders why the number of shares outstanding does not change after a repurchase of what looked to have been 5% or so of shares outstanding during the year. 

Well, that’s because management keeps awarding themselves options, which are approved by the board. And the options have the effect of selling the business incrementally to the managers over time, unless share purchases eliminate the dilution from issuing the options.  Why approve the options packages? Well, the option packages are marketed to the share owners as critical to attracting and retaining good managers, AND, aligning the interests of management with the interests of shareholders. Which is where Mr. Santayana comes in  –  the bad (for shareholders) is made to look good with the right buzzwords.

However, I think there is another reason. Obviously growing a business is one of the most important things a management can do with shareholder capital. But today, every capital allocation move of reinvesting in a business for growth and expansion directly or by acquisition, faces a barrage of criticism. The comparison is always against the choices of dividends or share repurchase. I think the real reason is somewhat more mundane. 

The quality of analysts on both the buy and sell side has been dumbed down to the point that they no longer know how to go out and evaluate the impact of an acquisition or other growth strategy. They are limited to running their spread sheet models against industry statistics that they pull off of their Bloomberg terminals. I remember the horror with which I was greeted when I suggested to an analyst that perhaps his understanding of a company and its business would improve if he would find out what bars near a company’s plants and headquarters were favorites of the company’s employees on a Friday after work and go sit there. Now actually I wasn’t serious about that (most of the analysts I knew lacked the social graces and skills to pull it off). I was serious about getting tickets to industry tradeshows and talking to the competitor salespeople at their booths.  You would be amazed about how much you can learn about a company and its products that way. And people love to talk about what they do and how it stands up against their competition. That was a stratagem that fell on deaf ears because you actually had to spend real dollars (rather than commission dollars), and you had to spend time out of the office. Horrors!  You might have to miss a few softball games.

The other part of this is managements and the boards, which also have become deficient at understanding the paths of growing and reinvesting in a business that was entrusted to them.

Sadly, what we have today is a mercenary class of professional managers who can and will flit from opportunity to opportunity, never really understanding (or loving) the business. And we also have a mercenary class of professional board members, who spend their post-management days running their own little business – a board portfolio. And if you doubt all of this, take a look again at Valeant and the people on the board and running the business. It was and is a world of consultants and financial engineers, reapplying the same case study or stratagem they had used many times before. The end result is often a hollowed-out shell of a company, looking good to appearances but rotting away on the inside.

By Edward Studzinski 

The Weather

By Edward A. Studzinski

“When we unleash the dogs of war, we must go where they take us.”

Dowager Countess of Grantham

Starting off one of these monthly discussions with a title about the weather should be indicative that this piece will perhaps be more disjointed than usual, but that is how the world and markets look to me at present. And there is very little in the way of rational explanation for why the things that are happening are happening. My friend Larry Jeddeloh, of The Institutional Strategist, would argue that this country has been on a credit cycle rather than a business cycle for more than fifteen years now. Growth in the economy is tied to the price and availability of credit. But the cost of high yield debt is rising as spreads blow out, so having lots of cheap credit available is not doing much to grow the economy. Put another way, those who need to be able to borrow to either sustain or grow their business, can’t. A friend in the investment banking business told me yesterday about a charter school that has been trying to refinance a debt package for several years now, and has not been able to (thank you, Dodd-Frank). So once again we find ourselves in a situation where those who don’t need the money can easily borrow, and those who need it, are having difficulty obtaining it. We see this in another area, where consumers, rather than spend and take on more debt, have pulled back.

Why? We truly are in a moment of deflation on the one hand (think fuel and energy costs) and the hints of inflation on the other (think food, property taxes, and prescription drug costs on the other). And the debt overload, especially public debt, has reached a point where something has to be done other than kicking the can down the road, or other major crisis. I would argue we are on the cusp of that crisis now, where illiquidity and an inability to refinance, is increasingly a problem in the capital markets. And we see that, where the business models of businesses such as energy-related master limited partnerships, premised on always being able to refinance or raise more equity, face issues.

I was reading through some old articles recently, and came across the transcript in Hermes, the Columbia Business School publication, of a seminar held in May 1985 there. The speakers were Warren Buffett, James Rogers, Jr., and Donald Kurtz. As is often the case, sifting through the older Buffett can be rewarding albeit frustrating when you realize he saw something way before its time. One of the things Buffett said then was that, based on his observations of our political system, “ … there is a small but not insignificant probability that we will lose fiscal control at some point.” His point was that given a choice, politicians will always opt for an implicit tax rather than an explicit tax. If expenditures should determine the level of explicit taxes, than taxes should cover expenditures. Instead, we have built in implicit taxation, expecting inflation to cover things without the citizens realizing it (just as you are not supposed to notice how much smaller the contents are with the packaging changes in food products – dramatically increasing your food budget).

The easier way to think of this is that politicians will always do what allows them to keep doing what they like, which is to stay in office. Hence, the bias ends up being to debase the currency through the printing presses. So you say, what’s the problem? We have more deflation than inflation at this point?

And the problem is, if you look at history, especially Weimar Germany, you see that you had bouts of severe inflation and sharp deflationary periods – things did not move in a straight line.

Now we have had many years of a bull market in stocks and other assets, which was supposed to create wealth, which would than drive increases in consumption. The wealth aspect happened, especially for the top 5%, but the consumption did not necessarily follow, especially for those lower on the economic ladder. So now we see stock and asset prices not rising, and the unspoken fear is – is recession coming?

My take on it, is that we have been in a huge jobless recovery for most of the country, that the energy patch and those industries related to it (and the banks that lent money) are now beyond entering recession, and that those effects will continue to ripple through the rest of the economy. Already we see that, with earnings estimates for the S&P 500 continuing to drift lower. So for most of you, again, my suggestion is to pay attention to what your investment time horizons and risk tolerances are.

Moving totally down a different path, I would like to suggest that an article in the February 28, 2016 New York Sunday Times Magazine entitled “Stocks & Bots” is well worth a read. The focus of the article is about the extent to which automation will eliminate jobs in the financial services industry going forward. We are not talking about clerks and order entry positions. That revolution has already taken place, with computerized trading over the last twenty years cutting by way of example, the number of employees buying and selling stock over the phone from 600 to 4 at one of the major investment banking firms. No, we are talking about the next level of change, where the analysts start getting replaced by search programs and algorithms. And it then moves on from there to the people who provide financial advice. Will the Millennials seek financial advice from programs rather than stock brokers? Will the demand grow exponentially for cheaper investment products?

I think the answer to these questions is yes, the Millennials will do things very differently in terms of utilizing financial services, and the profit margins of many of today’s investment products, such as mutual funds, will be driven much lower in the not too distant future. Anecdotally, when one has a year in the markets like 2015 and the beginning of 2016, many investment firms would push down the bonus levels and payments from the highest paid to take care of the lower ranks of employees. I was not surprised however to hear that one of the largest asset managers in the world, based in Boston, had its senior employees elect to keep the bonuses high at the “partner” levels and not take care of the next levels down this past year. They could see the handwriting on the wall.

All of which brings me back to the weather. Probably suggesting that one should read a politically incorrect writer like Mark Twain is anathema to many today, but I do so love his speech on the New England weather. For a preview for those so inclined, “The lightning there is peculiar; it is so convincing that, when it strikes a thing it doesn’t leave enough of that thing behind for you tell whether – Well, you’d think it was something valuable, and a Congressman had been there.”

At a future point I will come back for a discussion of Mr. Twain’s essay “On the Decay of the Art of Lying” which might be essential reading as this year’s elections take shape.

Edward A. Studzinski

This Time It Really Is Different!

By Edward A. Studzinski

“Every revolution evaporates and leaves behind only the slime of a new bureaucracy.”

 Kafka

So, time now for something of a follow-up to my suggestion of a year ago that a family unit should own no more than ten mutual funds. As some will recall, I was instructed by “She Who Must Be Obeyed” to follow my own advice and get our own number of fund investments down from the more than twenty-five where it had been. We are now down to sixteen, which includes money market funds. My first observation would be that this is not as easy to do as I thought it would be, especially when you are starting from something of an ark approach (one of these, two of those). It is far easier to do when you start to build your portfolio from scratch, when you can be ruthless about diversification. That is, you don’t really need two large cap growth or four value funds. You may only add a new fund if you get rid of an old fund. You are quite specific about setting out the reasons for investing in a fund, and you are equally disciplined about getting rid of it when the reasons for owning it change, e.g. asset bloat, change in managers, style drift, no fund managers who are in Boston, etc., etc.

Which brings me to a point that I think will be controversial – for most families, mutual fund ownership should be concentrated in tax-exempt (retirement accounts) if taxes matter. And mutual fund ownership in retirement accounts should emphasize passive investments to maximize the effects of lower fees on compounding. It also lessens the likelihood of an active manager shooting himself or herself in the foot by selling the wrong thing at the wrong time because of a need to meet redemptions, or dare I suggest it, panic or depression overwhelm the manager’s common sense in maintaining an investment position (which often hits short seller specialists more than long only investors, but that is another story for another day).

The reasons for this will become clearer as holdings come out for 12/31 and 3/31, as well as asset levels (which will let you know what redemptions are – the rumor is that they are large). It will also become pretty clear as you look at your tax forms from your taxable fund accounts and are wondering where the money will come from to pay the capital gains that were triggered by the manager’s need to raise funds (actually they probably didn’t need to sell to meet redemptions as they all have bank lines of credit in place to cover those periods when redemptions exceed cash on hand, but …..).

The other thing to keep in mind about index funds that are widely diversified (a total market fund for instance) – yes, it will lag on the upside against a concentrated fund that does well. But it will also do better on the downside than a concentrated fund that does not do well. Look at it this way – a fifty stock portfolio that has a number of three and four per cent positions, especially in the energy or energy services sector this past year, that has seen those decline by 50% or more, has a lot of ground to make up. A total stock market portfolio that has a thousand or more positions – one or two or twenty or thirty bad stocks, do not cripple it. And in retirement accounts, it is the compounding effect that you want. The other issue of course is that the index funds will stay fully invested in the indices, rather than be caught out underinvested because they were trying to balance out exiting positions with adding positions with meeting redemptions. The one exception here would be for funds where the inefficiencies of an asset class can lead to a positive sustainable alpha by a good active manager – look for that manager as one to invest with in either taxable or tax-exempt accounts.

China, China, China, All the Time

In both the financial print press and the financial media on television and cable, much of the “blame” for market volatility is attributed to nervousness about the Chinese economy, the Chinese stock market, in fact everything to do with China. There generally appear to be two sorts of stories about China these days. One recurring theme is that they are novices at capital markets, currencies, as well as dealing with volatility and transparency in their markets, and that this has exacerbated trends in the swings in the Shanghai market, which has spread to other emerging markets. Another element of this particular them is that China’s economy is slowing and was not transparent to begin with, and that lack of growth will flow through and send the rest of the world into recession. Now, mind you, we are talking about economic growth that by most accounts, has slowed from high single digits recently (above 7%) to what will be a range going forward of low to still mid-single digits (4 – 7%).

I think a couple of comments are in order about this first theme. One, the Shanghai market has very much been intended as a punter’s market, where not necessarily the best companies are listed (somewhat like Vancouver in Canada twenty-odd years ago). The best companies in China are listed on the Hong Kong market – always have been, and will continue to be for the foreseeable future. The second thing to be said is that if you think things happen in China by accident or because they have lost control, you don’t understand very much about China and its thousands of years of history. Let’s be realistic here – the currency is controlled, interest rates are controlled, the companies are controlled, the economy is controlled – so while there may be random events and undercurrents going on, they are probably not the ones we are seeing or are worried about.

This brings me to the second different theme you hear about China these days, which is that China and the Chinese economy have carried the global economy for the last several years, and that even last year, their contribution to the world economy was quite substantial. I realize this runs counter to stories that you hear emanating from Washington, DC these days, but much that you hear emanating from Washington now is quite surreal. But let’s look at a few things. China still has $3 trillion dollars of foreign exchange reserves. China does not look to be a debtor nation. China has really not a lot of places left to spend money domestically since they have a modern transportation infrastructure and, they have built lots of ghost cities that could be occupied by a still growing population. And while China has goods that are manufactured that they would like to export, the rest of the world is not in a buying mood. A rumor which I keep hearing, is that they have more than 30,000 metric tons of gold reserves with which to back their currency, should they so choose (by comparison, the US as of October 2014 was thought to have about 4,200 metric tons in Fort Knox).

For those familiar with magic shows and sleight of hand tricks, I think this is what we are seeing now. Those who watch the cable financial news shows come away with the impression that the world is ending in the Chinese equity markets, and that will cause the rest of the world to end as well. So while you are watching that, let’s see what you are missing. We have a currency that has become a second reserve currency to the world, supplanting the exclusive role of the U.S. dollar as countries that are commodity economies now price their commodities and do trade deals in Chinese currency. And, notwithstanding that, the prices of commodities have fallen considerably, we continue to see acquisition and investment in the securing of commodities (at fire sale prices) by China. And finally, we have a major expansion by China in Africa, where it is securing arable land to provide another bread basket for itself for the future, as well as an area to send parts of it population.

And let me suggest in passing that the one place China could elect to spend massively in their domestic economy is to build up their defense establishment far beyond what they have done to date. After all, President Reagan launched a massive arms build-up by the US during his terms in office, which in effect bankrupted the Soviets as they tried to keep up. One wonders whether we would or could try to keep up should China elect to do the same to us at this point.

So, dear readers, I will leave it to you to figure out which theme you prefer, although I suspect it depends on your time horizon. But let me emphasize again – looking at the equity markets in China means looking at the wrong things. By the end of this year, we should have a better sense of whether the industrial economy is China has undergone a rather strong recovery, driven by the wealth of a growing middle class (which is really quite entrepreneurial, and which to put it into context, should be approaching by the end of this year, 400M in size). And it will really also become clear that much of the capital that has been rumored to be “fleeing” China has to be split out to account for that which is investment in other parts of the world. Paying attention to those investment outflows will give you some insight as to why China still thinks of and refers to itself as, “The Middle Kingdom.”

Edward A. Studzinski

Where Are the Jedi When You Need Them?

By Edward A. Studzinski

“In present-day America it’s very difficult, when commenting on events of the day, to invent something so bizarre that it might not actually come to pass while your piece is still on the presses.”

Calvin Trillin, remarking on the problems in writing satire today.

So, the year has ended and again there is no joy in Mudville. The investors have no yachts or NetJet cards but on a trailing fee basis, fund managers still got rich. The S&P 500, which by the way has 30-35% of the earnings of its component companies coming from overseas so it is internationally diversified, trounced most active managers again. We continued to see the acceleration of the generational shift at investment management companies, not necessarily having anything to do with the older generation becoming unfit or incompetent. After all, Warren Buffett is in his 80’s, Charlie Munger is even older, and Roy Neuberger kept working, I believe, well into his 90’s. No, most such changes have to do with appearances and marketing. The buzzword of the day is “succession planning.” In the investment management business, old is generally defined as 55 (at least in Boston at the two largest fund management firms in that town). But at least it is not Hollywood.

One manager I know who cut his teeth as a media analyst allegedly tried to secure a place as a contestant on “The Bachelor” through his industry contacts. Alas, he was told that at age 40 he was too old. Probably the best advice I had in this regard was a discussion with a senior infantry commander, who explained to me that at 22, a man (or woman) was probably too old to be in the front lines in battle. They no longer believed they couldn’t be killed. The same applies to investment management, where the younger folks, especially when dealing with other people’s money, think that this time the “new, new thing” really is new and this time it really is different. That is a little bit of what we have seen in the energy and commodity sectors this year, as people kept doubling down and buying on the dips. This is not to say that I am without sin in this regard myself, but at a certain point, experience does cause one to stand back and reassess. Those looking for further insight, I would advise doing a search on the word “Passchendaele.” Continuing to double down on investments especially where the profit of the underlying business is tied to the price of a commodity has often proved to be a fool’s errand.

The period between Christmas and New Year’s Day is when I usually try to catch up on seeing movies. If you go to the first showing in the morning, you get both the discounted price and, a theater that is usually pretty empty. This year, we saw two movies. I highly recommend both of them. One of them was “The Big Short” based on the book by Michael Lewis. The other was “Spotlight” which was about The Boston Globe’s breaking of the scandal involving abusive priests in the Archdiocese of Boston.

Now, I suspect many of you will see “The Big Short” and think it is hyped-up entertainment. That of course, the real estate bubble with massive fraud taking place in the underwriting and placement of mortgages happened in 2006-2008 but ….. Yes, it happened. And a very small group of people, as you will see in the story, saw it, thought something did not make sense, asked questions, researched, and made a great deal of money going against the conventional wisdom. They did not just avoid the area (don’t invest in thrifts or banks, don’t invest in home building stocks, don’t invest in mortgage guaranty insurers) but found vehicles to invest in that would go up as the housing market bubble burst and the mortgages became worthless. I wish I could tell you I was likewise as smart to have made those contrary investments. I wasn’t. However, I did know something was wrong, based on my days at a bank and on its asset-liability committee. When mortgages stopped being retained on the books by the institutions that had made them and were packaged to be sold into the secondary market (and then securitized), it was clear that, without ongoing accountability, underwriting standards were being stretched. Why? With gain-on-sale accounting, profits and bonuses were increased and stock options went into the money. That was one of the reasons I refused to drink the thrift/bank Kool-Aid (not the only time I did not go along to get along, but we really don’t change after the age of 8). One food for thought question – are we seeing a replay event in China, tied as their boom was to residential construction and real estate?

One of the great scenes in the “Big Short” is when two individuals from New York fly down to Florida to check on the housing market and find unfinished construction, mortgages on homes being occupied by renters, people owning four or five homes trying to flip them, and totally bogus underwriting on mortgage lending. The point here is that they did the research – they went and looked. Often in fund management, a lot of people did not do that. After all, fill-in-the blank sell-side firm would not be recommending purchase of equities in home builders or mortgage lenders, without actually doing the real due diligence. Leaving aside the question of conflicts of interest, it was not that difficult to go look at the underlying properties and check valuations out against the deeds in the Recorder’s Office (there is a reason why there are tax stamps on deeds). So you might miss a few of your kid’s Little League games. But what resonates most with me is that no senior executive that I can remember from any of the big investment banks, the big thrifts, the big commercial banks was criminally charged and went to jail. Instead, what seems to have worked is what I will call the “good German defense.” And another aside, in China, there is still capital punishment and what are capital crimes is defined differently than here.

This brings me to “Spotlight” where one of the great lines is, “We all knew something was going on and we didn’t do anything about it.” And the reason it resonates with me is that you see a similar conspiracy of silence in the financial services industry. Does the investor come first or the consultant? Is it most important that the assets grow so the parent company gets a bigger return on its investment, or is investment performance most important? John Bogle, when he has spoken about conflicts of interest, is right when he talks about the many conflicts that came about when investment firms were allowed to sell themselves and basically eliminate personal responsibility.

This year, we have seen the poster child for what is wrong with this business with the ongoing mess at The Third Avenue Funds. There is a lot that has been written so far. I expect more will be written (and maybe even some litigation to boot). I commend all of you to the extensive pieces that have appeared in the Wall Street Journal. But what they highlight that I don’t think has been paid enough attention to is the problem of a roll-up investment (one company buying up and owning multiple investment management firms) with absentee masters. In the case of Third Avenue, we have Affiliated Managers Group owning, as reported by the WSJ, 60% of Third Avenue, and those at Third Avenue keeping a 40% stake (to incentivize them). With other companies from Europe, such as Allianz, the percentages may change but the ownership is always majority. So, 60% of the revenues come off the top, and the locals are left to grow the business, reinvest in it by hiring and retaining talent, focus on investment performance, etc., with their percentage Unfortunately, when the Emperor is several states, or an ocean away, one often does not know what is really going on. You get to see numbers, you get told what you want to hear (ISIS has been contained, Bill Gross is a distraction to the other people), and you accept it until something stops working.

So I leave you with my question for you all to ponder for 2016. Is the 1940 Act mutual fund industry, the next big short? Investors, compliments of Third Avenue, have now been reminded that daily liquidity and redemption is that until it is not. As I have mentioned before, this is an investment class with an unlimited duration and a mismatch of assets and liabilities. This is perhaps an unusual concern for a publication named “Mutual Fund Observer.” But I figure if nothing else, we can always start a separate publication called “Mutual Fund Managers Address Book” so you can go look at the mansions and townhouses in person.

Edward A. Studzinski