August 2020 IssueLong scroll reading

“He said what?”

By Edward A. Studzinski

“Why shouldn’t things be largely absurd, futile, and transitory? They are so, and we are so, and they and we go very well together.”

George Santayana, in a letter to Logan Pearsall Smith (24 May 1918) in The Works of George Santayana: The letters of George Santayana 1910 – 1920 (2002), p. 319

Another month of strong market performance. Another disconnect to what is going on in the domestic economy. For the month of July, the S&P 500 ground out a 5.5% gain. However, once you set aside the strong results of the large technology stocks, results in other sectors are clearly mixed. And that would appear to be true of both international and domestic markets.

The bigger concern of course is the contraction seen in the domestic economy, which is unparalleled even including the Great Depression. An article in the Chicago Tribune a few weeks ago indicated that some 4000 plus small businesses had closed in Illinois since the beginning of the pandemic (“From museums and restaurants to law firms and supermarkets, thousands of Chicago-area businesses got PPP loans worth $1 million or more,” 7/7/2020). More sobering was the estimate in the same article that roughly 50% of them would never reopen. Today’s Wall Street Journal (8/1/2020, paywall) floated an estimate that as many as 4 million small businesses could be lost entirely this year. Contrary to popular belief among politicians, Washington beltway insiders, and the denizens of Wall Street, small businesses are what drive growth in this country, so that is troubling for the future. Five years of economic growth have been wiped out. For those concerned that a strong economy in the hinterlands would lead to political results they did not favor, they have gotten their wish.

Carnage in Fund Land

David Snowball reports, monthly and at length, about some of the closures and restructurings going on in Fund Land. What is driving them? At the end of the day, it comes down to egos and greed. Obviously, the fact that many active managers have failed to keep up with their benchmarks has raised issues as to what one is getting in return for the fees being paid.

Senior executives at many firms see the handwriting on the wall.

However, as with icebergs, what is going on beneath the surface should be of more concern. The best explanation I can offer is that the senior executives at many firms see the handwriting on the wall. The business model that they thought was sustainable for their economic prosperity has ended or is winding down.

We have heard of one large firm in San Francisco which is a partnership where the partners buy in or are bought out at book value of the business. If assets under management, as a result of redemptions and market declines are down, then book value is down. If you were a partner scheduled to leave this year, you are not happy about the haircut your capital account is taking, so you drag your feet on retiring. The younger group, who think it should be their turn to step up, are not happy about being held back.

Variations on this are occurring around the country. In Boston at one large firm, if your retirement payout again is tied to the growth of the business over the next ten years, but not for the last five years of your fifteen-year payout, then your plans for retiring to Bar Harbor or the south of France, perhaps are put on hold or downgraded. The same is true at firms where there are unfunded deferred compensation plans as a retention benefit in a corporate holding company structure, except when the corporation decides that there is no reputational benefit to retaining underperforming fund managers.

225 funds and ETFs were either liquidated or merged out of existence in the first six months of 2020; the pace of liquidations – and the willingness to liquidate after just a year or two in operation – ticks steadily upward.

I am going to leave this by saying that there is going to be a continuing shakeout in the fund business. Those of you who have tied yourselves to your favorite firms for the last fifteen or twenty years perhaps need to rethink the issue of whether you have a Plan B or a Plan C for your assets, as change is going to occur. Not the last of that change will be driven by the platform companies such as Schwab, Fidelity, and Vanguard as their businesses evolve to put more emphasis on vehicles that tilt the playing field of fees in their direction. I will again point out that consolidation and change is happening.

Look at the sale of the USAA group of mutual funds to Victory, which gave Victory scale. This was followed by the sale of USAA’s investment management and brokerage business to Schwab. Look for similar transactions to keep happening, particularly in situations where management did not understand the difference between being a low-cost provider and a low-priced provider.

Global News

One of the more surprising things to me has been the almost exclusive focus in our domestic news reporting on three things: COVID and our response to it; the Presidential campaign; and the domestic economy and the stock market. Almost non-reported here was a major setback a few weeks ago to Iran’s nuclear program, which could have happened on another planet for all the news coverage it received.

I also continue to see a focus on our economy that ignores one basic fact. People in this country are not going to feel comfortable going back to work, resuming consumer spending, and doing all of the things that fed our economy, until they are comfortable that the virus is under control. Not that we have a vaccine, not that we have a treatment, but that the virus is under control. Which means that we need a consistent set of numbers and benchmarks that people can understand. To get there we need economists and public health people in the same room. And the politicians need to be locked up in some other room.

Which brings me to one other thing we are also not paying attention to, which is China’s economy in relation to the global economy (while our economy appears to be in freefall). Two things to look at are the Caixin Services Purchasing Managers Index as well as the Baltic Dry Index. The Baltic Dry Index is a shipping index, which rose from 500 in May to 1894 at the beginning of July. The Caixin Services PMI represents some 400 small and medium-sized enterprises, drivers of the Chinese economy. The index rose 6.2% in June, the highest level since April 2010. The cause was seen in the index for new orders, which is at the highest level in the last ten years, reflecting an increase in orders and backlogs.

The other point to pay attention to – shipping rates from Shanghai to the U.S. West Coast and the U.S. East Coast have continued to fall. But shipping rates from Shanghai to Northern Europe have quadrupled and from Shanghai to the Mediterranean have doubled. Some of this reflects China’s continuing efforts at building up strategic stockpiles. But it also reflects a determination to build up inventories so that the domestic Chinese economy can function (and thus minimize internal political disruption) no matter what is going on in the rest of the world. The conclusion then becomes that China will emerge from the pandemic in a stronger economic position than most other economies.

There are several takeaways from that. The investing ones are obvious, the trick will be finding those investment firms that can execute them, having built up the information network and infrastructure to stay ahead of the curve. Or put differently, global investment diversification will continue to be key for long-term investors. And in Asia especially, that information advantage will need to be gleaned from boots on the ground rather than on the internet, by people who understand cultural nuances.

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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.