January 2019 IssueLong scroll reading

The Year That Wasn’t!

By Edward A. Studzinski

“Human life is punishment.” Seneca

“Vīta hūmāna est supplicium,” Lucius Annaeus Seneca

Looking at the detritus of the year just passed and its effect on investment portfolios, the question that will be asked ad nauseam over the next four or five weeks will be some variant on “How did this happen?” The answer is rather short and simple. You, your mutual fund portfolio manager, and the asset management firm that the fund is part of, all were too greedy.

How so?

It has been pretty clear, certainly in regard to domestic equities, that valuations have been extended for some time. We have heard many explanations as to why that has not been the case, which are variations on “New Math.”

If you take out this and add back that, it’s cheap.

If you extrapolate normalized (whatever that is in this environment) earnings out two to three years and discount them back (but at what interest rate in a rising rate environment), it’s cheap.

These software and media companies are asset-light, and therefore should be valued differently than the traditional industrial companies we have invested in (just look at the private market transaction values – the new greater fool approach). They’re cheap.

So what if certain foreign media and internet companies don’t allow us to actually own common stock, but only sort of a stock-like certificate? They’re …

Here’s the math that matters. If your fund family hit a high-water mark of assets under management of $150B early on in the calendar year, that would have produced, assuming an all-in blended 1% fee and a constant run rate, $1.5B in revenue, half of which goes to the parent organization. By the end of November your assets are down to $120B, which means revenues are running at a $1.2B rate, and only $600M for you in-house.

This poses two questions? What happens if assets under management have dipped under $100B by year-end? And how do you stop the bleeding? Depending on absolute and relative performance, some heads should roll (and spare us the “bad year for everyone” and “who could have predicted” nonsense). The heads should be the accountable heads, not some poor schmucks who have not been the investment decision makers. Just because you call someone a co-portfolio manager, doesn’t mean the person did anything but sit for a photo shoot. In that vein, I hold up Tweedy, Browne as an example, where I am told all five members of the investment committee, all senior partners, have to agree before an equity is bought or sold. You understand the accountability at that firm.

Active investment managers are bleeding badly, and it’s not going to stop until they hold themselves to a dramatically higher standard.

Stopping the bleeding is a more difficult question. Have your investors lost faith in you? As a fund manager or fund organization, disclosing an investment given the SEC ranges (more than X$) probably doesn’t go far enough any longer. And saying that at these prices, you have added to your fund investments also doesn’t go far enough. I think the example of Longleaf Asset Management should apply. With very rare exceptions, no equity investments by firm employees should be permitted in vehicles other than the funds managed by the firm. No clone investment limited partnerships, no real estate partnerships, no outside investment partnerships, no individual common stocks, nada. If you are going to talk about skin in the game, let’s have real skin in the game.

Some of you may think this is especially harsh and unrealistic, given that investment talent can easily go down the elevator and out the door. Let them. I want to share with you a comment that a retired investment banker made to me recently. And the comment was that most of the sovereign asset funds as well as the private offices for those European families with billions of dollars of personal wealth, have been forty to fifty per cent in cash since June. Why, he asked, do American institutional and retail investors, after more than five years of above-average returns, think they have to try and time the top of the market? After all, the focus should be on investing for generations, for the long-term, not milking out the last hundred basis points of return in hopes of a bigger bonus. If your talent is unwilling to commit to the same products you are asking the investors to invest in, lose them. Don’t pretend you are taking on the same risks as the investors, especially if fund personnel are fleeing the organization’s products. As an exercise, look at the 9/30/2018 financials and then 12/31/2018 financials for your funds. See what level of cash they were carrying. That will give you an indication as to whether the fund company was investing OPM (other people’s money) or catering to the financial consultants.

We Love Shareholder Friendly Managements

One of the phrases I have come to hate is “we invest in companies that have shareholder friendly managements.” This is then expanded to define them as companies where the management’s focus on the appropriate capital allocation, usually defined as repurchasing stock or paying dividends when appropriate. I can’t think of when I heard those capital allocation discussions include “investing in the growth of the firm’s business.” Which makes me wonder how many companies have become hollowed-out over the years. Yes, there are some businesses that are just commodity businesses, like banking, where adding branches or making an acquisition used to be the limit of what could be done. But now that branch banking networks are superfluous in a world of electronic banking, investing in technology (as well as cyber-security) may be a better use of capital than just shrinking the share count or paying out a dividend. A few years ago, I asked a friend who was on the board of a multinational Chicago-based financial institution what kind of money they were spending on cyber-security. His answer was that they were spending a fortune and they knew it was not enough.

In 2018, management spent more to buy back its stock, $1.1 trillion dollars, often at inflated valuations, than it committed to investing in its actual operations and almost 20x more than it spent on cybersecurity.

Does share repurchase make sense? Sometimes. But it is not a panacea for a declining business, especially if we are talking about a slow death. Often share repurchase is just being used to eliminate the dilution caused by stock options issued to executives. And that is a mistake I and other investment managers recognized too late. We should never have gone along with the managements on that. We thought we were aligning interests. Instead we gave them a way to own a company for free.

The Year Ahead

I have been reminded recently that I have not come back to the issue I raised some years ago that most investors owned too many funds, and perhaps fewer than ten was appropriate. I also remain committed to my idea that equity funds should only be owned in tax-exempt accounts. I will come back to those issues in some detail. Perhaps that will be in tandem with a piece about funds that should no longer exist. I would suggest that if a Morningstar-rating puts a fund for all periods observed in the 90th decile or higher, either the fund should not exist or you should no longer be an investor, if indeed you are. Things for you to look forward to in the New Year.

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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.