December 2016 IssueLong scroll 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 a larger institution, which pays a price which is usually justified by the “synergies” and “cost savings” that will occur as the expenses for operating the business will be deployed over a larger platform. Translated, “we will eliminate as many older, expensive employees as we can, since banking is basically a commodity business, where the lowest cost provider wins.” The same rationale is often applied to various lines of business. If it is a business that the acquiring bank is in, it will be folded into the existing model. If it is not, then they will try and apply their model to it to make it meet their profitability metrics. The problem with that is that some businesses require specialty knowledge.

Such appears to be the case with the issues raised in this proxy fight. Most unusual I thought was the letter enclosed with the proxy materials from Lee Ann Anderson, who had been with TexasBank and Compass Bank, and resigned to join Southwest Bank. She has been involved in oil and gas royalty trust administration (and the oil and gas business) for more than twenty years. Let me quote from some of the comments made in that letter.

“When I resigned, Compass Bank gave “X” a “field promotion” to Vice President and Senior Trust Officer, an office I spent 15-20 years to earn, after only eighteen months of experience as an oil and gas manager with Compass Bank. “X’s” background before joining Compass Bank in 2014 was in land title examination, not oil and gas accounting or operations. In “X’s” deposition relating to the pending Burlington litigation in January 2016, he admitted under oath that he had no experience in the administration of royalty trusts, no experience with SEC filings, and very little experience with oil and gas other than relating to title work. Prior to assuming full responsibility of the Trust, he spent only four days of training with me for background on the Trust’s administration and history. He had very little acquaintance with trusts involving oil and gas assets prior to February 2014, and none of these were publicly traded.”

Now, if you thought that was insufficient to raise questions, let me quote from one more following paragraph in the letter:

“We believe that Compass Bank’s reference to individuals with 25 years of experience with the Trust is misleading. The only remaining employee of Compass Bank with any long-term experience working on the Trust, while a capable clerical assistant, has never acted in a managerial role or had any responsibility for discretionary decision-making for the Trust.”

So, what if anything does this have to do with mutual funds? These kinds of issues can’t occur with mutual funds, a highly regulated business, often run by Chartered Financial Analysts who have a code of ethics that they should be adhering to in carrying out their responsibilities. Well, dear reader, I have a surprise for you. Given that greed and the dictates of the marketing department often hold sway, misstatements concerning the experience and backgrounds of portfolio managers and analysts happen more often than one would like. And absent depositions under oath, one usually doesn’t know that as an individual investor getting ready to make an investment decision.

Christmas List Book Review

James Cloonan, who founded the American Association of Individual Investors, has a new book out called Investing at Level 3, which I commend to all of you. One of his comments with which I, a value investor, agree is that “unnecessary fear of volatility results in investors throwing away returns to offset risk that doesn’t really exist for the long-term investor” which he labels “ghost risk.” Volatility in the marketplace, whether for the indices or for individual securities, often presents the long-term investor with the tremendous opportunity for returns. But if you think mutual funds are the solution, Cloonan goes on to describe a multitude of problems with mutual funds, including poor performance: high fees and loads; and lack of truly independent directors. We have touched on these before, but Cloonan points out that as to the directors or trustees of a fund, the investment advisory firm (a) chooses the independent directors; (b) determines the remuneration and expense policy for the independent directors; and (c) can terminate directors. I suggest you all take time to read the prospectus and Statement of Additional Information and familiarize yourself with biographies and compensation.

They won’t say what you really would like to see – “Z is a retired blah-blah in need of additional compensation to support his life style in retirement and a long-time friend of Q, the director of investment research for the firm.” Reality, especially in the mutual fund business, is not really like the Citicorp commercial extolling the virtues of what life would be like if people really said what they meant.

In any event, read the book. It raises a lot of questions that people should work through as they try and determine how to design and implement their own investment programs, especially as pertains to retirement.

The Endowment Guru

My favorite financial writer for the New York Times, Gretchen Morgenson, on November 6th did a long piece about David Swensen, the legendary endowment manager for Yale University. Swensen has also written some books, one about investing for endowments, and one for individuals. As he wrote the one for individuals, he discovered that he couldn’t tell them to do what he did in allocating to various pools of assets, as individuals could not access the same managers he could, and at the same prices. So, for the average investor he is pretty much a proponent of low-cost index funds.

The article is interesting because it fleshes out some things that would not be apparent otherwise. The Yale Endowment Investment Department has a weekly meeting to debate investment ideas, and real debate is what is called for. In retrospect, I can tell you that you often can’t tell when the culture at a firm changes, and real intellectual debate is replaced by a form of pandering. It is telling for instance that in evaluating outside managers, Swensen’s group will not focus on the historic track record of the managers in question, but rather, how good they might be going forward.

In the article, Swensen indicates a willingness to stick with managers, notwithstanding relatively short-term market swings in volatility and thus market value. As he puts it, “Who cares about the trailing numbers if the fundamentals of the portfolio are good?” Well, if you are an asset-gatherer, you do worry about the trailing numbers, because rather than flowing in, the assets will flow out as most consultants and individual investors don’t have that long-term time horizon. Swensen does not like the asset gatherers, who have built large investment funds by attracting many individual investors. “More assets produce more fees, but they force managers to add more positions, not just Grade A ideas,” says Swensen. Former employees at the Yale Endowment have said that one of the most important things they learned in evaluating managers is finding out how well they know their portfolio. If the manager has to bring in an analyst to explain the investment, or refer to a summary sheet, that is probably not someone you want to entrust with your money. Again, read the full article, which is in the Business Section of the November 6, 2016 Sunday New York Times.

So, this month, as we look toward year-end, I encourage many of you to do some of the reading I have suggested as you consider how to allocate your investment portfolios for the future, relative to your goals and objectives, and respective ages. Obviously, at this point predicting taxes for the future is a fool’s errand. Try and determine whether you have placed some or all of your money with asset-gathering organizations, for it is a certainty that those organizations place your investment returns as secondary to the profits of the business that they are running. Apply the same advice to your own portfolios in terms of evaluating what you own. If you can’t remember why you did it, or need someone else to explain it to you, it is probably not what you should be doing. Above all, focus on the long-term.

Happy Holidays!

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. 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 nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. 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 defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. 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 and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.