Category Archives: Local Charterholders

Biomimicry and the Nature of Investing

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Tom Brakke, CFA

Modern markets can seem to operate in a sphere of their own, divorced from the real economy and the real world. Plus, the process of investing has become more systematized and abstract over the last couple of decades – with the theory and jargon of the business often conveying a sense of false precision about the behavior of markets.

As a portfolio manager and former head of U.S. equity research at Fidelity, Katherine Collins felt those disconnections and yearned for a broader perspective. Her radical career shift – heading off to Harvard Divinity School – left her co-workers and others surprised. How could she leave the exciting business of investing?

As Collins told a recent meeting of CFA Society Minnesota, she never abandoned her love for investing. But she wanted to find a new context for her decision making, and her experience at divinity school, the Santa Fe Institute, and the Biomimicry Institute led her to use the lessons of nature to approach the challenges of investment analysis.

Her insights can be found in a new book, The Nature of Investing: Resilient Investment Strategies through Biomimicry, and she formed Honeybee Capital to produce research using her approach. (More information can be found in an interview with Collins in CFA Institute Magazine.)

Many of the precepts that Collins discussed involved cutting through the complexity of the investment conventions of today with simple concepts inspired by nature. She talked about the honeybees which gave her firm its name, pointing out how they cooperate to share information “openly and without spin.” When faced with a problem, they head out into the world to observe and then work together toward an optimal solution. Contrast that with many investment decision makers, laboring away alone in their offices, looking at the world through digital windows.

In fact, for people of a certain age, one of Collins’ examples was particularly apt. Back in the day when not everyone had a Quotron (the dominant electronic data platform then), they used shared terminals in common areas. That had at least two positive effects: co-workers rubbed shoulders more often and got to know each other better, strengthening the teamwork in the organization, and they shared information about their respective areas of expertise, resulting in a cross-pollination of ideas that yielded new insights. According to Collins, “the inefficiency of the Quotron was what made it so special.”

Yes, “we have become tools of our tools,” that derivation of a Thoreau quote being one of many that Collins used to show how the challenges we face aren’t exactly new (although with amped-up tools we probably have amped-up challenges). We feel like we have all of the answers at our fingertips, but only to certain questions, and probably not the key ones.

For Collins, the most important result of her inquiry into biomimicry is that it helps her to ask better questions about the investment process. She gave a number of examples of unusual adaptations among species that led her to see an investment dilemma in a new light.

The biggest issue that we confront is “risk” versus “uncertainty.” The former is bounded by the parameters of our experience, and the investment world has turned it into an apparent science. Risk equals standard deviation (although that’s a very unusual definition) and the language of risk in that sense has become universal, driving the investment framework for everyone from individuals to massive institutions. This “land of risk” is mapped and quantified – and our tools are honed to guide us within the normality that we think exists.

But the “sea of uncertainty” is something else again. It’s ironic that the financial crisis caused the risk culture to become even more entrenched; it should have exposed the shortcomings of that framework for dealing with unanticipated situations. Collins thinks that those who tread the land of risk (an overwhelming percentage of investment professionals these days) are least equipped to navigate on the sea of uncertainty. To survive in the entire range of environments, we need people that come at decisions from other directions – and ask those better questions – rather than trying to outthink and out-model everyone else.

Speaking of thinking, Collins grew up with one mantra ever-present in her life: “Think.” Her father worked for IBM, so she couldn’t get away from that famous slogan from founder Thomas Watson. But it’s easy to get lost in your own thoughts (sitting in your office with your electronic tools) or to get caught up in the conventional thinking about an investment question.

Thinking differently is essential (yet difficult), and Collins says we need better systems for approaching problems and better conversations about them. Long-term perspective is needed to succeed in a world driven by short-term performance.

That demands a reengagement with realms beyond the echo chamber of the investment business. In many ways, we have become removed from the reality of our decisions. A stock is not a blip on a screen but an economic interest in a company. As someone schooled in fundamental analysis, Collins stressed the importance of understanding the culture of a firm, and “you can’t do it in ten minutes.” You also can’t capture the world with a bunch of statistics, although they are an important part of the information mosaic (just not as important as we’ve come to believe).

Collins is an engaging speaker, sharing insights from within the investment business and from outside of it, and effectively connecting the two. You can’t help but think that you’d want her around the table the next time you had a tough issue to address – or when you needed reminding that sometimes you have to take a step out into the real world to see things in new ways.

Numbers Geek

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John Boylan, CFA

What most lay people don’t know about people in our industry is what complete number geeks we really are. Geeky to the point where we have passionate feelings about our preferred calculator brand. For instance, we named our graduate school intramural football team “The HP 12Cs”, after our financial calculator of choice. Yes, we are numbers driven people and are passionate on how they are used in the investment process depending on where we are in the investment cycle.

One thing I am noticing talking with fellow investors is how the numbers, as measured in earnings-based valuations, are leading them to fewer potential buy candidates as the market continues to grind higher. There have been non-stop debates if the market is under/overvalued since the beginning of this rally. As usual, it depends upon the numbers you look at for your reference point. The Schiller P/E chart, for instance appears to show that the market is near the top end of its historical range.

 

Chart: Historic Shiller P/E Ratios

(click on image to enlarge graph)

Chart Historic Shiller PE Ratios_FABlog

Source: gurufocus.com

Additionally, looking at corporate profits as a percent of GDP can lead investors to wonder where the next leg of earnings growth may be.

 

Chart: Corporate Profits After Tax/Gross Domestic Product

(click on image to enlarge graph)

Chart Corporate Profits After TaxGross Domestic Product_FA Blog

Source: Federal Reserve Bank of St. Louis  

 

Sometimes, seemingly at least in part, at the expense of average household incomes.

 

Chart: Real Median Household Income in the United States

(click on image to enlarge graph)

Chart Real Median Household Income in the United States_FABlog

Source: Federal Reserve Bank of St. Louis  

 

Still others offer compelling evidence (along with several charts, see link) that the market can continue to rally. Recent positive GDP data along with good ISM data (57.1, arguably a healthy reading and up from last month) and a progressing jobs picture may support further market gains.

 

Chart: ISM Manufacturing: PMI Composite Index

(click on image to enlarge graph)

Chart ISM Manufacturing PMI Composite Index_FABlog

Source: Federal Reserve Bank of St. Louis  

 

Personal feelings on how the market will perform in the near/mid-term aside (I think we will do OK as long as the market has confidence in the Fed and its tactics and/or if it will come to the rescue every time the market has a hot lava burp), the question I normally ask myself when there is a lot of high valuation discussions is not what will the market do next, but what is the best valuation methodology to use with a given security at this stage of the cycle. Especially since so many of us need to be fully invested regardless of market conditions.

Why? Because usually when there is much debate about stock valuations being too high we investors sometimes can get caught up in earnings stories that will likely evolve beyond our investment horizon (if at all) to justify the current heightened valuation. This in my experience usually led me to two separate risks: getting led into a value trap hoping that a poorly run laggard would catch up to its peers over time or relying on earnings estimates two or even three fiscal years out.

Usually in these circumstances I tend to gravitate toward revenue based methodologies, such as price/sales and top line growth rates. I always thought that 50%+ of valuation work starts with revenues to begin with as so many estimates on all financial statements are driven by this line item. Additionally if the market continues to gravitate towards growth stocks I avoid value traps by only focusing on companies that can deliver on top line growth instead of focusing on margins and earnings that may never come. Conversely if the market begins to slip, if I focus on companies with a lower price to sales ratio, I don’t have to worry as much about discretionary actions a management team might do in a downturn such as delay or cut a stock buyback program, or what cuts they may make to “make the earnings number” in the short term but could harm future growth.

World’s Cup Runneth Over

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Once again, one of the world’s central bankers was in charge of the game. On Wednesday, the FOMC released its much anticipated statement, confirming as expected that the Fed would continue to taper its bond purchase program. Its 2014 growth outlook was slightly lower, but not very negative. If there was any surprise, it came during Yellen’s press conference, when she spooked a few corners of the bond market by dismissing recent inflation figures as noise. This led to a steepening of the yield curve which persisted into Thursday. It seemed to be exacerbated by the 30-year TIPS (treasury inflation protected securities) auction, which didn’t go quite as well as dealers were expecting. Nominal 30 year levels recovered sharply on Friday – but still ended the week higher by about 4 basis points. It seems that the bond market is struggling to figure out the FOMC’s next step. It may be that the FOMC is struggling to figure out its next step.

There was no uncertainty, however, on the part of credit markets, which once again took its cues from a Dovish central bank. Not worried about any increase in inflation, 10 year bank spreads rallied by 5 basis points or so, and higher vol sectors like materials have also had a good week. Utilities felt like they lagged a bit, so data all around showed support for the central bank-induced risk-on trade. The World Cup of liquidity continues to flow.

The new issue market, on the other hand, slowed down this week. Most issuers tried to get in ahead of the Fed, so Monday and Tuesday were the big days, with about 80% of the week’s volume. Total supply this week was just over $20 billion, so a pretty slow week overall. The week had more than its share of energy companies, as Cameron, ERP Operating, and Hess all brought deals to market. The interesting trade of the week was our local friend Target – the company had to widen the price from initial talk in order to get its deal done, which we haven’t seen in a while. The company brought $2 billion total, $1 billion of a 5 year at +60, and $1 billion of a 10 year at +90. These bonds ended up among the better performers on the week, so the initial guidance wasn’t that far off, but the market demanded a concession given the noise around the company’s story recently.

So in the end, we think it was a pretty solid week for credit. Should we be worried about liquidity driven bubbles? Maybe, but I think we’ll just focus on soccer for now. Gooooooooaaaaaal!

Inversion Layer

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John Boylan, CFA

The recent popularity of tax inversion strategies got me to thinking about what might be the toughest thing to do when analyzing a company. Namely determining what its optimal capital and tax structure could be. Most of the time, I tend to rely more on free cash flow analysis than trying to forecast capital structure or determine optimal tax considerations. I figure if I develop a reasonable and attainable cash flow forecast it would be easier to determine what the use of that cash might be. Even then I tended to be off in my cash use prediction because of the Curse of the Financial Analyst—we think tend to think every business decision is a financial decision. More often than not many other business and management considerations are of equal, if not higher, importance. We as analysts often forget that.

For example, why don’t more companies take advantage of tax inversion strategies? Management might feel uncomfortable having essentially two headquarters, one for executive management and one for day to day operations—some managements may feel uncomfortable managing crucial functions remotely. Some might feel that tax advantages and loopholes can shift over time for a variety of reasons, meaning a company may have to move its headquarters more than once to keep their tax saving strategy intact (e.g. Accenture moved to Ireland from Bermuda due to changes in tax considerations). Additionally some companies might see longer term opportunities for that cash that could offer a better return, even after taxes. This might include investments in research and development, marketing and distribution, new capacity, acquisitions, and the like. It also depends on where the cash resides and the opportunities, or lack thereof, there might be in that market.

Still as shareholders we often want as much cash returned to us from our investments as quickly as possible, and managements need to respect the will of its owners when it makes sense to do so over the long run. It really comes down in my view where the management and investors believe the company is in its growth cycle. If it is early on in the cycle I would rather see cash spent on growth, which also lowers a company’s tax bill without adding more managerial complexity to the organization. If the company is in a more mature industry I would rather see the company managed for cash flow and see that money returned to investors. Therefore in reality, I think that we need to take as close of a look at the personality and management style of its executive team and determine if their longer term goals match where we think the company is in its growth cycle as much as we do trying to determine what companies may be best suited for a change in capital or tax structure on a pure numbers basis.

Best Practices in Asset Manager Communications

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Tom Brakke, CFA

“The numbers speak for themselves.”

What asset manager with great numbers hasn’t wanted to toss a pitch book down on the table, utter those words, and wait for questions (only to return to the phrase over and over again in response to them)?

There are a few who have adopted that strategy (Bernard Madoff, for one, and some take-it-or-leave-it hedge fund managers), but for the most part it doesn’t fly for firms trying to win new institutional clients, even when the numbers are outstanding.

Therefore, an asset management firm must have a good communications strategy (and stick to it) if it is to succeed over time. The best practices for doing so were the topic of a recent presentation to CFA Society Minnesota by Judith McKinney and Gordon Dickinson of Callan Associates.

The presenters stressed the importance of a thorough communications strategy that is consistently applied. That’s a challenge, given that individuals have different styles and portfolio managers would prefer to be back at their desks evaluating ideas rather than answering questions about how they do what they do.

Large firms can marshal the brute force of their resources to hone such a strategy and to produce outstanding materials, but their presentations can lack the personality and display of camaraderie that are second nature for those at a small firm that are used to working closely together.

Each element of the communications chain needs attention, including requests for proposals, presentations for new business (and for review meetings), newsletters, white papers, websites, meetings with consultants, and whatever other opportunities exist to reinforce a firm’s message.

Through it all, there needs to be an ethos of quality, accuracy, integrity, and honesty. Superior materials and presentations provide a platform from which to convey the key messages that the manager wants to deliver.

The dynamics of a presentation for new business are critically important. The pitch book (whether in hard copy or on a screen) can be an effective vehicle through which the proper message is conveyed or a framework for failure, so the speakers from Callan spent a good deal of time reviewing its construction and delivery.

They said that “95% of the decks are pretty good” in following the four Ps – philosophy, people, process, and performance. A common problem is getting “bogged down in too many details” rather than concentrating on delivering a compelling narrative; they stress that “the appendix is your best friend.” Put the minutiae there.

In fact, “the best presenters don’t use the book very much.” They make eye contact, they connect with the audience, and they tell their story.

The flow of a presentation probably seems unimportant in the scheme of things, but several times the speakers from Callan talked about the quality of the transitions from one member of a presenting team to another. The little things matter, which is why practice is critical and thorough preparation often separates the managers that “show well” from those that don’t.

The most spirited interaction between members of the audience and the presenters from Callan revolved around the degree to which consulting firms are pro-cyclical in their approach to the recommendation of strategies and the selection of managers – going with recent winners rather than seeking out good managers who have been struggling. The discussion was prompted by a statement in the presentation deck that when meeting with consultants, managers should “focus on an investment product/strategy that is doing well; underperforming strategies may be non-actionable for the consultant.”

So, the numbers may not speak for themselves completely, but they speak very, very loudly. In the mutual fund world, “a five-star rating is the trigger for acceptance” (even though it is based upon past performance) and for an institutional mandate, “if you’re in the finals you don’t even have to talk about performance; you wouldn’t be there without performance.”

Therefore, the biggest hurdle to be jumped over in order to be hired is good performance. On the flip side, many good firms are fired because of a spot of poor performance. The representatives from Callan said that a big part of their job is trying to talk clients out of firing managers, but they stressed how behaviorally difficult it is for those clients – and for themselves – to go against the flow. They could cite just one situation where Callan recommended a firm that had subpar performance over the past few years but what they felt was the foundation for good performance going forward. (It turned out very well.)

The meeting featured much good information for asset managers looking to improve their communications practices – and I would not minimize the importance of the recommendations. But it is disheartening to be reminded that at its roots, this is a business of herding, and numbers, for the most part, speak louder than words, even if experience shows that they can be deceiving.