April 2017 IssueLong scroll 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 his prior employer, PIMCO. If public accounts are accepted, Gross is receiving a settlement payment in the vicinity of $80M. Since it is hard to believe that PIMCO, and their owners, Allianz, the German insurer, are in the habit of throwing money around for no good reason, it appears that Mr. Gross may have had a more than colorable case. At the least, the discovery process would have provided some fascinating insights in terms of emails and phone records, into the PIMCO culture. Myself, I have always believed that the issues were centered on greed. A younger group of managers resented the amount of phantom equity or bonus pool units that Mr. Gross had, making their slices of the pool too small in their opinion. Get rid of Gross, and you can reallocate his units. Just raise a group of issues that allow you to move in that direction.

Mr. Gross was lucky in one regard. This was all taking place in California, which as a matter of public policy considers non-compete and other restrictive employment constraints to be null and void. So Mr. Gross was able to go out the door, move to Janus, keep his following, AND be in a position to litigate the issues. Had we been talking about Illinois, Massachusetts, or New York this debate would never have seen the light of day. Another case of at the least blatant age discrimination would have vanished.

Next, we have Cambridge Associates, one of the original investment consulting firms, restructuring its business by cutting professional staff, and indicating that they wanted to focus on a business model of being an outsourced chief investment officer for endowments. Big surprise of course, the primary shareholders of the privately–held firm were trying to figure a way to monetize their investment. Reminds me of the primary shareholder of a closely-held bank I know who had many chances to sell his bank at 2.5X tangible book value. He thought he could get 3X book ultimately so did not sell. Five years later, he ended up selling for about 1.8X tangible book, as in a period of economic stress, the book value (the primary metric for valuing banks and p&c insurance companies) first flattened and then began to regress backwards. Sometimes if you wait too long, you can miss the market.

We next have the curious case of Morningstar. My friend and colleague David Snowball is writing extensively in this issue about the Morningstar decision to launch their own group of proprietary mutual funds for their investment advisory clients. They will displace fifty existing funds from their Managed Portfolio program. So, is this a conflict of interest? Well, that depends on where you are sitting, and whether you want to believe in things like Chinese walls and management assurances. There is a certain amount of humor to be found in the fact that Morningstar’s equity research business took off when the Wall Street firms such as Morgan Stanley, caught by the SEC with having their analysts write reports at the behest of and to some extent scripted by the investment bankers, had to hire Morningstar to produce independent research for those firms’ brokerage clients. I have also listened to Morningstar executives tell me over the years that mutual funds were basically a bad business model for the INVESTOR, and that the coming of very low cost passive funds and exchange-traded funds would change the nature of the business forever. While that appears to be happening, this move to bring in hedge fund talent to run private label mutual funds seems to be an effort to go against the tide.

This then brings us to ponder the thought processes of Chairman of the Board $2.2 Billion net worth Joe Mansueto, and new CEO Kunal Kapoor in making this move now. I have no insights to offer other than to say that neither one of them appears to have the makings of a Jeff Bezos. David and I and the rest of the MFO family are grateful to them however, for the business opportunity they have presented us with, in being about the only ones who will be able to write objective evaluations of their new funds.

Lest you think that was a sufficient amount of disruption, BlackRock, the world’s largest asset manager, announced that it will be closing or rearranging its active fund lineup, laying off a number of professional staff – analysts and fund managers, and shifting to a group of quantitatively managed funds selectively.

They have the benefit of being actively managed, but can be offered at a much lower fee break point than fundamentally managed active funds, and still be extremely profitable.

I have always been a fan of blending a quantitative approach with fundamental analysis and active portfolio management. Indeed, while still at the Mercantile National Bank of Indiana, I used the investment research of both Chicago Investment Analytics, a quantitative multi-factor model shop, and Select Equity, which at the time was making available its individual stock research (which was attuned to high return on invested capital businesses). This allowed my bank’s common trust funds to compete quite handily against the industry Goliaths, even though we lacked a team of in-house analysts.

One benefit of that approach is that it serves as a check on the integrity of the analyst’s numbers. For example, I heard third-hand a while back the story of a young equity analyst who was frustrated that he could not get his new stock ideas approved and purchased. A senior equity analyst allegedly told him, “What’s the problem, just make up some numbers that make your idea look better.” The young analyst is still frustrated while the senior analyst has since been promoted into executive management. Now you might think that rather fanciful, but I will tell you that a number of the quant/fundamental firms have teams of analysts scrubbing the numbers that go into their quantitative multi-factor models just to make sure that the fundamental side is not gaming the system.

R-E-S-P-E-C-T

I had two conversations this past month which were, I think, indicative of where we are now.

One was with David Marcus at Evermore Global, for whom I have a tremendous amount of respect (which started back before I personally knew him as I do now, but knew of him when he was running Mutual European Fund at Mutual Shares under Michael Price). I asked David whom he respected who was running money today. The universe he cited was very small, probably less than ten, which shrunk even more when you factored in the question of whether they were still investors or had been swept up by “the business” of running a mutual fund or an investment management firm. The number of names I had was equally small, well under ten. The sad part about this was that often asset bloat was the triggering factor of change, which shifted priorities away from finding good ideas and investing in them.

The other conversation I had was with my friend and former colleague, Robert Sanborn. We were discussing investing for endowments, since he sits on three endowment committees, as well as changes in the mutual fund world. I reminded him of one of our other former colleagues, who used to obsess about finding the best investments until he became a mutual fund portfolio manager. The obsession changed to finding the best investments given the business he was in (scalability, liquidity, etc.). Robert, off the top of his head quoted the words from “Godfather II” with which I opened this piece.

So my readers, I leave you with this. Should you attend the Morningstar Conference at the end of this month, or should you be watching either Bloomberg TV or MSNBC, and there is a speaker being interviewed or a speaker making a pitch presentation, I want you to visualize the scene with Hyman Roth and Michael Corleone again in your mind. Ask yourself if that is not what you are really seeing, over and over again.

This entry was posted in Edward on by .

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.