September 2017 IssueLong scroll reading

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 “Two Paradigms” which speaks of the convergence of the philosophies of John Bogle and Warren Buffett. Given my view that the investment management business, especially at the top, is increasingly populated by narcissistic sociopaths, it is refreshing to find someone like Joel Tillinghast who is thought of as a genuinely nice man who happens to be an outstanding investor. I highly recommend the book.

Meltdown of the Managers

As August ended, we had the juxtaposition of two events in Chicago. One was the announced closing of Holland Capital Management by year-end, an investment firm with a long history and still $2.5B of assets under management. The second was the story that ran in Bloomberg News this week quoting John Rogers of Ariel Capital Management as saying that in response to pressure from his fund trustees, the fees on several of the firm’s mutual funds would be reduced. The trustees wanted the fees to be at the industry average or lower for the fund category. Rogers indicated that the fee cuts were critical in an environment where institutional clients were moving their assets to either passive indexed products or exchange traded funds.

We have spoken a lot in the past about fees, perhaps ad nauseam. The response we have seen to the fee pressure, from a number of firms such as Fidelity, has been to hatchet costs so as to maintain profit margins on the investment products. A side issue is that over the years, there have been a lot of hidden levers providing an additional kick to the profit margins. Research for years could be purchased with commission dollars, known as soft dollars. And before that, many firms had their own brokerage operations where they were running trades, representing that they were meeting their fiduciary responsibilities for best execution, but in reality, juicing up their own profits. It was not unusual, as a fiscal year drew to a close, to see a chief executive officer in the trading room, flogging the traders to run more business through the owned brokerage operation before fiscal year-end. Those practices have been regulated away. And now of course, we have the unbundling of commissions and research, with brokerage firms charging hard dollars for their research (we will leave aside for the moment the question of whether institutional research is worth anything these days, recognizing that the sell side firms have gone through their own cost-cutting exercises, getting rid of years of institutional memories in their analyst resources to replace them with kids with computers and spreadsheets). All that notwithstanding, the money management business is still a very good business, perhaps almost as good as the tobacco or spirits businesses in terms of margins. It begs the question though as to whether like tobacco, the 1940’s Act mutual fund is outdated AND harmful to the user. I suspect my colleague Charles might say it is, and the exchange-traded fund is the better next generational product. I don’t know myself. I think there are interesting questions and arguments on both sides.

What I do know is that, whether we are talking about money management firms in Boston, Chicago, or New York, I hear a lot about toxic working environments, where analysts and portfolio managers spend much of their time at work being afraid and worrying about internal politics. One marketing executive I spoke to talked about the annual review process where she related the constant fee pressure from the clients (as John Rogers has now publicly confirmed), only to be told that the responsibility of the marketer was to bring in the assets regardless of the environment. So while I am a fan of active management and think it will have its day, unfortunately I think too many active managers are faced with the job security question which requires them to be fully invested to the last penny. And woe unto them if they question the valuation of the investments they are putting client money into (at the same time as they are restricting their own equity investments).

Regenerative Virginity

When you look at the groupings of mutual fund trustees, you find a category of insider trustees (connected to the management firm) and another category of outside independent trustees. One of the most magical processes is that by which an insider management trustee becomes independent under the rules, merely with the passage of time, to wit, three years. Think of it – you have an insider who was a senior executive at the parent fund company, where he has made millions of dollars for himself. He has acquired many of the firms under the umbrella of the parent company, so he knows a lot about valuing fund companies and the vagaries of dealing with investment personnel. He knows how profitable the business is, and how long the payback on the original purchase prices of firms tends to have been. He has set up share plans, which provide for the transfer of equity interests from senior personnel to junior personnel through the repatriation of share units at retirement. He is aware of the compensation processes and abilities of all of the key personnel at the fund company whose funds of which he is now a trustee. After three years, he gets to be declared an independent trustee and say that he knows nothing about the business at any level. For that he gets paid hundreds of thousands of dollars a year, paid for by the shareholders of the funds. Is this a great country or what?

On another note, no wonder that Brian Winterflood, who founded Winterflood Securities in London, feels that most “managers just want your money upfront for a fee.” And he would say that many managers at this juncture are overhyped investors whose results don’t justify the fees being charged.

To circle back to Mr. Tillinghast, more often than not, under the pressure of keeping assets, we are increasingly finding money management firms committing other people’s money on the basis of sloppy research, which leads to “reckless speculation” and “risky investments.”

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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.