Actively Speaking Podcast

Winning at Active Management with Epoch CEO Bill Priest

June 18, 2019 Epoch Investment Partners Episode 1
Actively Speaking Podcast
Winning at Active Management with Epoch CEO Bill Priest
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Actively Speaking Podcast
Winning at Active Management with Epoch CEO Bill Priest
Jun 18, 2019 Episode 1
Epoch Investment Partners

In Actively Speaking's inaugural episode, Epoch CEO Bill Priest joins host Steve Bleiberg to discuss winning at active management. (June 18, 2019)

Show Notes Transcript

In Actively Speaking's inaugural episode, Epoch CEO Bill Priest joins host Steve Bleiberg to discuss winning at active management. (June 18, 2019)

Speaker 1:

[inaudible] .

Speaker 2:

Hello and welcome to actively speaking. I'm your host, Steve Bleiberg . Join US each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Welcome everyone to the very first episode of actively speaking and I'm very excited to be joined today by bill priest who is the CEO of epic as well as the Co CIO and I co founder of the firm and for a podcast called actively speaking, we thought what better topic for our first episode than to talk about active management. Then more specifically the, the debate that's going on for many years now about active versus passive. I thought I would start off by just for giving the background. I'm not sure everybody , uh, at this point remembers where indexing came from or where the idea behind passive management comes from. So , uh , I'm just gonna take a minute to go through that background and talk about some of the problems with the , uh, the arguments for it. The idea for passive management really springs from modern portfolio theory. Uh, going back to the 1960s, really going back to Harry Markowitz is a famous paper in the 1950s about portfolio selection and it was, it was that paper that set up the idea that the way you measured the risk of a, of an asset or a portfolio was to use the volatility of the returns that that asset generates and and modern portfolio theory is , is built on that very heroic assumption that that one number captures the risk , uh , of any stock or any portfolio. And the , the attraction of that way of thinking is that it's an objective number. It does matter who's doing the measuring. The standard deviation of , of a series of numbers is what it is. And so if you define that a use that as your definition of risk, we can all agree on what the riskiness of a, of a given stock is or a portfolio. And when you go through the logic of, of modern portfolio theory, which views the world through that quote mean variance lens, where variants again as refers to the variants of the returns, I'm not going to go through the derivation here, but it gets you to this point where you say, well, there's this one portfolio where you don't know what it is, but there's this one portfolio out there which you can combine with cash in various mixes depending on your risk tolerance. And that's the best. That's the optimal portfolio. What's the , is this one portfolio? And then there's a logical deduction basically from that point. It's not a mathematical proof. It's really a logical deduction that, well, what's the one portfolio that we could all out ? I mean, if it's an optimal portfolio and we all agree it's optimal because again, we all agree on, in this framework on what risk is. Uh, so if there's this one optimal portfolio, surely we would all want to own that same portfolio. What was the only portfolio we can all own at the same time? It's gotta be the market. Because if any one of us overweights something or underweight something, then by definition somebody else has to be on the other side of that , that waiting that over or under waiting . So we wouldn't all hold the same portfolio. So in essence, we all hold a miniature version of the market or if you view the other way around, the market is just the aggregate of this same portfolio that we all own. So that's really where the , the logic of indexing comes from. Uh , this idea that there is an optimal portfolio. The problem with this is that the idea that standard deviation of returns captures what, how people perceive risk , uh, is really just not accurate. And in particular , uh, in , in subsequent years, there's been a lot of work by behavioral economics, behavioral finance theorists , uh , pointing out that , uh , there's this phenomenon of loss aversion that we all have where to me, we gain of a of a 10% return might be offset by the pain of a, of a 5% loss. But for you, it might be that the gay , the pleasure of a , or the, the positive utility of a 10% gain is offset. They would take a 9% loss to offset that. And so therefore you and I are not going to , uh, look at , at a stock or a portfolio and agree on how risky it is. We're going to have different perceptions of the riskiness of that. And if that's the case, then it's really hard to conclude that that there's one portfolio that we would all agree is optimal because we're going to have different perceptions of the riskiness for that portfolio. So that's really kind of the flaw in the original logic behind, behind the indexing and passive management. Um, but Phil , let me, let me ask you, there's, there's another issue , uh , when it comes to passive management, which is, there's this weird paradox that if more p the more people adopted, you would think that the market would become actually less efficient , uh , because there'd be fewer people trying to figure out what things are worth. But do you have any thoughts on that?

Speaker 3:

Thanks, Steve. Uh, actually if you go back to the 60s and I was there, so to speak at the time, and a very well known investor at that time , uh , Roger Murray who was head of Gia Cref and I was teaching at Columbia at the time , um, led a discussion of indexation and basically referred to it as being unamerican and the crowd cheered , uh, you rapidly go ahead 50 years and indexation takes a major, major role in the investment , uh, world today. And I think next month we may very well see passive assets in total exceed the actively managed assets. If you think about it , uh, back in the 60s, everyone was an active manager at one point and in effect the market was quite efficient in the sense of price discovery with all of those participants. So in a way, index fund, the index fund itself got a free ride on the price discovery of all the participants. Now as you fast forward to today, there's still this free rider effect, but it's much, much less than you would think. Uh, the fewer people doing active management means there's less work being done on price discovery, which is the heart of , of , uh , of efficiency of markets. So at some point , uh , you can make continue to see fewer active managers, but there has to be some, there will always be a remnant of active management because there has to be priced discovery. What proportion of asset managers that is or proportion of assets, I don't know. But without it, you run into a lot of issues surrounding price discovery evaluation and you can see it to some extent today if you look at various factors within any given factor that people are looking at you. So you can see the correlation of the names within that factor. The correlation among those names is actually rising, suggesting that people are buying a collection of securities or a subset, if you will. And there may not be a lot of price discovery there. That actually opens up a real opportunity for active management. Uh , and in that case, I think the , the better managers will indeed be able to exploit that. And , um, and I can imagine it will continue to prosper, but you have to demonstrate value add in a number of ways to do that. Uh, the most popular one perhaps is using something called the information ratio, but again, it reverts back to some of these common , um, common subs standards , uh, that you mentioned earlier, Steve, like standard deviation and whatnot. This asymmetry is , is really important. Uh, most people that I know really don't value a dollar gain the same way they would value a dollar loss. Uh, if you're extremely rich , um , $1 million might be a $5 bill to you. But for most people, when they start to lose a five figure sum , it means a lot more to them than it does if they were to make it. So this asymmetry has yet to be played out, but it's clearly there and you can see it in the literature,

Speaker 2:

right? Well, I mean, it has to be asymmetric because you know, you can, you can have a, supposed it were the case that, you know, a 50% gain was the, it was the exact opposite of a 50% loss. Okay, well then what would be the opposite of 120% gain? You know, there's no such thing as 120% loss. So there's gotta be an asymmetry there. But they really, the key thing is that it varies from person to person and that that's, that's really the key point is that we can't , um, the , you know, the, the sort of, the dream of modern portfolio theory is that there's this objective measure of risk that's independent of what doesn't matter who it is because they , well, everybody's going to agree this is, this number captures the risk of this asset . And the , the point about loss of version is that it varies from person to person. And so we can't agree on, on a level risk . You mentioned, sorry, a second ago about , um, some of the inefficiencies that would arise. Uh, if there's more passive management. And you mentioned ETF phenomenon and there've been studies of this, that stocks that are part of, you know, popular like sector UTS or , or ETFs that focus on some particular topic. Um, they do become, they are becoming more correlated with the other stocks within the ETF and actually less correlated with their own fundamentals. So in other words, the, the, you know, like the earnings reports are , are driving those stocks less than they used to and they're being more driven by just if people decide they want exposure to that industry and they buy the ETF, all the stocks that ETF get pushed up at the same time. Um, there's also evidence that , uh, we actually wrote about this in one of our white papers. Um, I think it's from, I think from 2017 , uh, about , uh , the, it's called the , uh, impact of passive investing and market efficiency. It's on our website , um, that bid ask spreads have begun to widen in stocks that , uh , the more, the more it gets , uh, the more of its shares are held by an ETF. And the less by you know, individual people, whether it's institutions such as ourselves or we're individual shareholders. But the more that the , the greater the percentage of the stock that is held by ETFs, the genuine , the wider the bid ask spread gets. Um, there's evidence that there's an interesting study few years ago looking at stocks including the s and p 500 that they, they trade at higher valuation multiples than stocks outside of the index. Even when you hold all other things equal as much as you can. And , and which raises the question of , you know, can active managers capture those, those inefficiencies because you might say, hey look these, these you can , for example, you could go short the s and p 500 and along a a basket of stocks that are not in the index, but then look kind of like the index and you say, ah , I'm going to capture that valuation arbitrage. But you know, if there's a continuing wave of money going into, into the s and p 500 passively, the ETFs or index funds, you could get swamped by that. While you're waiting for that, that a valuation anomaly to correct, you could, you can , you know, go out of business waiting for that to happen. Um, so that , that's an interesting topic is, you know, can can active managers actually profit from this?

Speaker 3:

Well , I think part of it, well two things come to mind and we have a colleague who repeatedly says, you can't manage what you can't measure. And this is almost a fetish in some cases, particularly with quantitative managers. But Einstein had to come back for that and Einstein said, not everything that counts can be counted and I'll know everything that can be counted counts. And I think it's within those two phrases that active and passive , uh, live uncomfortably together. Uh , if you have all active, I think there's really a case for , um, for indexation. But the further you get into indexation, the opportunity opens up for the fact that hey, many things that can't be counted really count . And I think we tried to put this together in the book that we wrote with our colleague Mike. Well holter . We felt that to , to win an active management, it required first and attitude as expressed in culture. And I think culture matters and I think the culture has to be, but the client's got to win. And if the client doesn't win , uh , it's a problem. And even the very aspiration statement that we have, we see it everyday on our computer when we light it up there, there are three things that matter. Uh, we, we want to provide positive risk adjusted performance to the client. We also want the client to understand and value how we do what we do because if they don't understand how and why we do what we do, you're in a situation where you're hired by the numbers and fired by the numbers and that probably is, is not not optimal. And the third thing is we like to think that , uh, we can, we will be seen as thought leaders in the business and frankly, thanks to the work that you've done and some a , and the rest of us , uh , epic over time has written something like a hundred white papers. And many of them I think are really, really quite good. And , uh, when I, when I look at what you need to succeed though, through all of that, it is the philosophy what determines value. And I , as we've talked about many times, cashflow drives the value of any business. Earnings are an accounting assumption. Uh, as we point out in a number of papers, earnings are kind of astrology. Cash flow is more like astronomy , uh, businesses run on cash and cash flow. And , uh, any investing model or investing philosophy needs to be built around that. So, and the things that really matter are understanding how that cashflow is generated. And the second question is, how does management allocate that cash flow ? And there's only five things they can do with a dollar of , of a cashflow . And , uh, for the record, we should probably define what we mean by cash flow . And we often use a phrase , a phrase called free cash flow. And what we mean by that is free cashflow as the cash available for distribution to shareholders after all planned capital expenditures and all cash taxes. At the end of the day, there's only five things that any management can do with that money. They can pay a cash dividend, they can buy back stock, you can pay down debt, they can make an acquisition, they can reinvest in their business. And their , the real question is can they generate a premium over their cost of capital? Uh , and if they can then reinvesting in acquiring a will probably make the most sense. Otherwise when they have that dollar of free cash flow, if they can't generate their cost of capital, they should give it back to the owners of the business. And we've essentially built all of our products around those concepts. Yeah. Well it's just going to , I'm just going to turn next to the book and the subtitle of the book was the essential rules of culture, philosophy and technology. Do you want to talk more about culture a little bit? Uh, uh, you know , what do you think are the important aspects of, of, of the successful asset management firms culture? Well, I think all firms in any business have a culture. You may not realize it until you arrived there and experience it. Uh, but every entity has a culture. It be a for profit entry and non for profit and entity. But there's a culture present and I think the cultures that matter , uh, if you're in the , if you're in the business of exchanging knowledge , uh, you have to look at the structure of that entity. And we've often contrasted the command and control model that you see in large organizations, banks, insurance companies, the military , uh, and there's no other way for these organizations to function except you , this, this structure. On the other hand, if you're in the knowledge exchange business, like a consulting firm, arguably a law firm or an investment firm , a partnership model is a much better structure. And the , uh, the idea is that there is a, a very small hierarchy and it's a horizontal one that you want to achieve and you want to collect people who, because of their nature and, or the incentive structures that they will collaborate. Collaboration is the heart, I think of, of a good culture that people will work together and pursuing the objective. And making sure that the client wins. So on the culture side, I think it's very important that , uh , that we have a situation where people feel that they're part of the organization. And I often think that when you look, when we look at hiring people, people join a firm or stay at a farm or leave a farm for three reasons. The first reason is do I like my colleagues? Because if you don't like your colleagues, life can be pretty challenging. Um , the second issue, and it varies by age and experience , but do I have a platform from which to grow my human capital? Uh , am I going to be around people who are going to make me better? So to speak? That doesn't mean better in the firm you're in necessarily. Just means that your personal growth as bread or you're able to grow your human capital. Uh, the third reason is I call it the reward module. It has two components to it. Part of it is compensation. Uh, you want to think that you're being paid fairly in the, they , you say yes to an offer. By definition, supply meets demand. At that point in time, it's fair. Uh , let me change your mind the next day, but that day it's fair. But the second more po component of that module is what I call moving the needle. It's making a difference. And uh, this one of the first questions that I like to delve into with the perspective employee because frankly, a firm of our size with 115 people or so, there are many large firms that could on pay for outbid a us for any human being that uh , that might be available. But that person needs to want to make a difference. If it's, if it's in his personality or her personalities, the case may be to feel that I want to go somewhere where I matter and I make a difference. I call it moving the needle. If that's part of your DNA, then affirmed like that because really a good place for you. Because we're small enough that we can't have a failure. We can, we can't have 10% of the people not doing the jobs of the military. Have 10% of the people aren't doing your jobs. It's probably not a big deal, at least in peace time. Uh, but , uh, it's a different story. At a smaller firm, everybody has got to feel that they matter and that they are moving the needle and collectively the firm as a product of, of those individuals.

Speaker 2:

Okay. Uh , yeah, the middle. So the middle part of the book was about philosophy and you touched on that with uh, talking about epics , philosophy on the importance of cashflow generation, how companies allocate cash flow and how they allocate that cash flow to it's five possible uses. I'll just add that , uh , one of the things we also talked about in there was that if you're going to succeed as an active manager, you need to , uh , identify something, you know, and understand that the market does process a lot of information pretty well. And markets are not dumb. They are pretty efficient , uh , but they're not perfectly efficient, but they, you know, they're reasonably good at processing a lot of information. So you have to identify some reason to believe why the market is wrong about certain companies. What is it that people are missing? Is there some systematic bias in the way people process the information? Are there just other, other behavioral biases that come into play about what causes people to like certain kinds of companies that are exhibiting certain characteristics or dislike other kinds of companies. Uh, and as we say in the book, cast a wide net , um, meaning, you know, you just got to sort of figure on if he own enough of these names , uh, you know, that's, you're going to get the signals so to speak and, and, and eliminate the noise. And obviously portfolio construction is an important part of that too in filtering out the noise. Um, and then the last bit , which, which brings us to the third part of the book. We are about technology. Uh, that's related to the portfolio construction part, but it has a much broader meaning really. Uh, how do you think t to succeed at active management, what do you think the role of technology should be? I don't think, I

Speaker 3:

think you can succeed in this business while incorporating technology into the process of security, selection, portfolio construction, and even trading all the, if you think about what it takes to manage money, there is this issue of security selection, portfolio construction where you're essentially controlling risk and exposures, if you will, to different kinds of risks. And then you have to be able to trade effectively. Well, or how do you know if, if you're doing a good job, and I think as time has gone by , uh , you can weave technology into that. And many, many years ago we sent a memo out internally about racing with the machine. There are some things that computers do better than we do. They can sort faster, they can do a lot of things better and quicker. So what you want to do is keep the judgment part of the equation with the human being, but you want to get, if you can put as much of the other on , on to , uh , onto the machine. So one of the things that I, just a personal anecdote, but I can remember when I first came in this business, I was a railroad analyst and I was given a job of kind of looking at railroad security's railroad equities to see if they were attractive. And I was in the process of building a model for the industry and the time, this is pre computers , uh, we had an electromechanical calculators on what you would, you would conduct studies. And uh , it took me many weeks, but I came up with a demand model for railroads. Uh , the key demands , a measure for a railroad is one ton of goods carried one mile . So think of it as ton miles. And so I built a stepwise regression program to explain a ton miles. And it turned out there were only three or four variables. And that was very powerful because as you went was you began to look at what you were learning. You learned that demand for much of the goods that railroads carried were inelastic. If you think about it, they carry commodities. They carried heavy cars at the time. They carried big, heavy things and there really weren't, at that time, a alternative modes of transportation. Occasionally you could do barges if you're going north and south, but if you're going east and west, it really was grain, durables, coal, those things. Well, that model was very powerful because it highlighted the fact that the mail was in inelastic and railroads, believe it or not, had a lot of pricing power. They didn't realize it at the time, but they did. Now that took me almost three months to write that paper. Visiting libraries, reading documents in the library . It took forever. That same study today can be done in an afternoon. All that data is available online and it's important that analysts be able to know how to use the data that's available to them. Um, so I think the key though is you want to keep the judgment with the human, but you want the collection of data to be done more and more effectively , uh, by, by embracing , uh , the machine. The, one of my favorite questions and talking to management. And in fact, I have two favorite questions. The first one, Steve, you alluded to earlier is how do you, how do you guys allocate capital if they were to say, well, we um , uh , we're a growth company. We reinvest every dollar internally either through acquisitions or internal capital projects. That's a terrible answer. A better answer would be we think our cost of capital is six seven, eight 9% to that we add 500 basis points , 600 basis points or some number to come up with a hurdle rate and we will reinvest or acquire down to that hurdle rate. And if there's any money left over, we give it back to the owners through cash dividends, buybacks or debt pay downs. That's a great answer. You don't know if they're any good at it. That's why you have analysts to kind of back test and take a look at and how they're allocating capital. But recently, a little over a year or so ago, I had a client say, so what's your digital strategy? That was an interesting question. I really didn't have an answer, but the more I thought about it, it was the wrong question. The right question is what is your business strategy in a digital age? And that's what the technology section of our book is about. We live in a digital age. It's very different than it was 10, 20, 30 years ago. You've alluded to it in terms of the active passive issue, but you can see it in risk management. You can see it in security selection and you're going to see more and more of it in our portfolios that are available for individuals to buy. If you're not racing with the machine. And if you don't have a business strategy for the digital age, I think you're going to die.

Speaker 2:

So the bottom line is that , uh , uh, to be successful, an active manager needs to use technology for what it's good at, but also needs to use human judgment for what the humans are good at. Because the data can , uh, you know, doesn't know everything. And uh, you know, sometimes the data is backward looking and you know, you need human judgment to to incorporate some of the forward-looking , I think it is

Speaker 3:

infusion of you can't manage what you can't measure at the same time Einstein was right and not everything accounts can be counted and not everything can be counted counts.

Speaker 2:

Okay. Well I think we'll leave it there. Thanks for joining us bill. Uh, this was the uh , the first episode of actively speaking, but I think I can say without fear of contradiction that you've been the best guests so far. Thank you so much. Great. Thanks for listening. Remember to subscribe to actively speaking on apple podcast or Google play. You can find all of our previous episodes and additional content on our website, www.eipny.com. We'll talk to you again soon. The information contained in this podcasts

Speaker 4:

is distributed for informational purposes only and should not be considered investment advice or recommendation of any particular security strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but as subject to change any performance information reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets or estimates in this podcast are forward looking statements and are based on epics , research, analysis and assumptions made by epic. There can be no assurances that such projections targets our estimates will occur and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returned or performance of any accounts and or funds managed by epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of security selected for clients and not all securities selected for clients in the past year. We're profitable.