Book Summary: Winning at active management

Epoch Investment Partners, Inc.

Book Summary:

Winning at active management

InveStment management CultureThe discussion begins at the level of the investment firm with an examination of the role of organizational culture in asset management. Culture can be thought of as the shared assumptions and principles that develop as a firm grows, through its handling of successes and challenges. Culture permeates every aspect of any business: operating strategy; products

and services; relationships with customers and within the organization; and the measurement of success and granting of rewards. Often a culture forms around the views of a firm’s founders, but it also grows from the bottom up, through the contributions of employees.

Organizational culture is a critical component of any professional service firm because much of the work produced is intangible, and the environments in which such firms work can change rapidly. Accordingly, the ideal culture for an investment manager is based on a “multiple leadership” model accompanied by the sharing of resources

authorSWilliam W. Priest, Steven D. Bleiberg, Michael A. Welhoelter with John Keefe

Our goal in writing Winning at Active Management was to consider, from our perspective as experienced professional investors, the current challenges in the investment management industry — the principles of the investing process, the industry’s vigorous debate over the value of active management, and the role of technology in portfolio management. The intended audience includes our investment manager colleagues, as well as the overseers of pension and endowment funds, and advisers to individual investors.

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and responsibility – what we term a professional partnership.

Shared effort, responsibility, and rewardWe view such a culture in three dimensions. The first is interdependence among different parts of a firm, which includes the formation of working teams, broad sharing of information, and shared accountability for the firm’s actions. Second is support among the firm’s partners: freely providing help and suggestions, as well as an obligation to raise concerns when a mistake or incorrect judgment may be in process. Third is a shared economic interest among the partners, which includes contributions of both capital and hard work, and balancing short-term rewards with the best interests of the firm.

Unlike the standard business measure, investment firms have special fiduciary obligations, and managers must place client interests above the desire to grow their own businesses. When that job is well done, clients, employees, and owners all are rewarded. At the founding of Epoch Investment Partners in 2004, we crystallized our aspirations into three statements, and they have formed the basis of our culture:

• To provide superior risk-adjusted results using a transparent approach based on our free cash flow philosophy;

• To serve investors who seek and value Epoch’s investment approach;

• To continue as a thought leader and innovator in global investment management.

InveStment phIloSophy and methodologyInvestment management is a complex undertaking, and calls for a well-reasoned

philosophy and methodology. For institutional investors, an articulated investment policy is often a legal requirement, but for many other investors, an investment philosophy may develop over time only through trial and error, or even unconsciously—not unlike some organizational cultures.

The great debateOne philosophical question debated for decades by asset owners, investment managers and consultants – with little progress toward a resolution – is whether superior long-term returns come from owning the stock market as a whole through passive indexes, or with actively managed portfolios that focus on selected securities.

Financial economists began rigorous study of investment risk and performance in the 1950s, and their early work resulted in the development of a comprehensive Modern Portfolio Theory (MPT) in the 1960s and 1970s. Simply stated, MPT holds that investors cannot outperform the broad market through security selection; that all investors view investment risk in one simple, rational way; and that the optimal portfolio for all investors is the broad market. These notions held great appeal for theorists: if valid, MPT would elegantly link the stock market with the economy, simplifying the process of investing and eliminating a lot of unnecessary effort (as well as commissions and fees). MPT took hold with many investment practitioners, and its concepts were expressed in passive strategies investing in market indexes beginning in the mid-1960s.

Behavioral finance versus mptBefore long, however, financial academics and investment practitioners started to find flaws in the conclusions of MPT. The empirical record turned out to be poor, in that its simple beta measure was a poor predictor of stock returns. This shortfall led a new generation of scholars to develop insights that better

matched real-world investor behavior. This new body of knowledge was named behavioral economics, and in contrast to MPT it holds that each investor perceives risk in a unique way. In our view, this more realistic view of investor behavior provides a justification for pursuing actively managed investment strategies.

Active managers’ results – causes and effectsWhile a credible case can be made that skillful managers can beat the market, their success in doing so has been uneven. For example, for the three and five years ended in December 2015, between 40% and 50% of managers of U.S. large-cap core equities outperformed the S&P 500. For the 10 years then ended, the proportion was far higher, at 69%. (All statistics are from eVestment, and reported before fees.)

In recent years the difficult task of active management has been made more challenging by the regimes of the financial markets. Since 2008, returns have been driven to a great extent by macroeconomic factors – in particular the unusual liquidity provided by quantitative easing programs of central banks around the world. One indicator of the challenge to active equity managers is the high correlation among stock returns since 2008: stocks have been moving more or less together and are influenced less by the health of companies’ individual businesses. Accordingly, managers face fewer opportunities to create a return better than the market. Another major impediment has been the extremely low return to cash: while passive managers typically hold little in reserve, active managers often keep 2% to 3% in cash. During the four years ended December 2015, the annualized cost of holding cash was about 0.6%.

Seeking free cash flowEpoch Investment Partners believes that active management can deliver above-market returns over the long run. Our investment process is based on selecting

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Book Summary: Winning at active management

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companies with a superior ability to generate free cash flow, and allocate it wisely – whether by reinvesting for capital growth (through internal projects or acquisitions), or returning capital to owners (via cash dividends, share repurchases, and debt repayment).

Free cash flow is the basic measure of value of a corporation, and successful security selection avoids relying on companies’ earnings as reported under generally accepted accounting principles (GAAP), and instead looks to cash flow as a more valid indicator of companies’ economic profit. Academic research has demonstrated that shares of firms that report higher-quality earnings – that contain a higher cash flow component and less in the way of accounting accruals – tend to demonstrate superior returns over the long run. Aggressive accounting may impress some investors for short periods, but ultimately the market sees through the artifice, and values the company on its ability to generate free cash flow. (An investment industry adage says “accounting earnings are an opinion, but cash flow is a fact.”)

Valuing companies on their free cash flow requires more analytical work than relying simply on reported accounting earnings, but it provides far better measures of companies’ underlying value. Nonetheless, we are not eager to see the abandonment of GAAP earnings reports: large numbers of investors continue to take their cues from them, and to the extent that accounting profits exaggerate true economic profits, they create inefficiencies in share prices and opportunities for active portfolio managers.

teChnology In InveStment managementComputer technology made its way into the corporate world during the 1950s, but its use was initially limited

to bookkeeping. In the early 1960s, however, a team of researchers engaged by Wells Fargo Bank set out to mechanize investing as well. They developed the first index fund in 1971, which required computer power to calculate portfolio weights and track transaction costs.

What followed was an explosion in the use of information technology in investing, a process which tracks a notion set out by Erik Brynjolfsson and Andrew McAfee in their 2014 book The Second Machine Age: computers became cheaper, more powerful and easier to use; increasing capacity and usefulness led to the amassing of digital financial databases; and innovative ideas, both theoretical and practical, became easier to combine and cross-fertilize. Today, every corner and aspect of the markets is highly computerized. Historically, new ideas have emerged on the investing side, prompting demand for new types of data, and forcing the transaction processing and custody side of the industry to catch up.

While some early practitioners relied on computers to advance the cause of MPT and passive investing, others saw opportunities in strategies that defied the assumptions of market efficiency. A new discipline, quantitative investing, enabled investors to scan the market widely for factors thought to generate superior returns, and then test their reliability over

time and in different market conditions. Building portfolios on fundamental factors is the central idea behind systematic strategies investing in value, growth, momentum, and low volatility; all are widely available in the institutional world, and accessible to individual investors as well through mutual funds and exchange-traded funds.

The Epoch Core ModelEpoch Investment Partners does not take a traditional view on growth versus value styles, or quantitative versus fundamental research techniques, as we don’t find those distinctions especially meaningful. However, we do firmly advocate active management, and quantitative methods are part of our investment process.

Considerable effort goes in to the decision to add a stock to an Epoch portfolio: developing a thorough understanding of the drivers of each company’s business, and forecasts of what is likely for the future. The final choices require detailed handwork from our research analysts and portfolio managers, but in many cases the initial steps of identifying suitable companies are handed off to the Epoch Core Model. It’s a quantitative tool that “casts a wide net,” sorting and ranking thousands of stocks across global markets and industries on a group of factors focused on the sources and uses of cash

authorS of Winning At Active Management

ChapterS 11 - 14

WilliAM W. PriEST, CFACEO, Co-CIO and Portfolio

Manager

epoCh InveStment partnerS

Steven d. BleIBerg Managing Director, Portfolio Manager

mIChael a. Welhoelter Managing Director, Portfolio

Manager and Head of Quantitative Research and

Risk Management

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flow and company quality. The Epoch Core Model enables analysts to apply their skill more effectively through better and more consistent investment processes. The model also increases breadth by increasing the number of stocks an analyst can research—without diminishing the ability to apply skill by having to reduce the time spent on each idea.

racing with the machineSince early 2015 Epoch has formalized and expanded the role of information technology into an initiative we call racing with the machine (a turn of phrase borrowed from Brynjolfsson and McAfee’s first book, Race Against the Machine). The aim is not to give over decision making to software algorithms, but instead recognize and incorporate the strengths of information technology and how it can inform the investment decision-making process. We want the “machine” to serve the analyst—not the other way around.

Epoch has recently developed and built a strategy that might not have been possible—and certainly not practical—without the application of mass digitization of financial data and

rapid computing power. (We have named the central idea Capital Reinvestment Opportunities.) However, it is not based on conventional quantitative models, or looking for new ephemeral bits of market information: instead, it applies our fundamental concepts of capital allocation, backed by insights of academic and market research.

In recent years, financial researchers have documented that profitability (defined as return on invested capital or ROIC) exerts an important influence on stock returns. The ROIC of individual companies is idiosyncratic, but for the market as a whole, ROIC tends to be consistent over fairly long periods, providing the basis for an attractive strategy. In terms of investment approach, Capital Reinvestment Opportunities offers a complement to Epoch’s existing products which select companies on how companies distribute free cash flow to owners.

In developing the strategy, we studied ROIC at companies in the MSCI World index for the 10 years ended 2015 – a massive analytical task. The results were encouraging: on average, 70% of the companies in the top quintile for ROIC in

a given year remained there in the next year, and few companies migrated from the top ranks of ROIC to the bottom over short periods. Significantly, shares of high ROIC companies tended to outperform those of less profitable firms.

In view of the conclusions drawn by academic researchers, it is not surprising that the market rewards astute investment and high ROIC. On the other hand, the persistence of such outperformance is puzzling, as it implies that investors do not fully price in companies’ results: the market seemed to be continually surprised that highly profitable companies would continue to be so.

The Value of JudgmentThis seeming contradiction is why Epoch supplements the output of quantitative models with the judgment of experienced investors – racing with the machine. Quantitative models “collect the dots”—efficiently gathering and sorting the raw information— while the analysts and portfolio managers “connect the dots” and conduct the security selection. In Epoch’s view, judgment can be greatly informed by technology, but technology will never be a substitute for judgment.

Book Summary: Winning at active management

The information contained in this presentation is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particu-lar 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 presentation is accurate as of the date submitted, but is subject to change. Any performance information referenced in this presentation represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this presentation are forward looking statements and are based on Epoch’s research, analysis, and assumptions made by Epoch. There can be no assurances that such projections, targets, or estimates will occur and the actual results may be materially different. Other events which were not taken into account in formulating such projections, targets, or estimates may occur and may significantly affect the returns or performance of any accounts and/or funds managed by Epoch. To the extent this presentation 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 securities selected for clients and not all securities selected for clients in the past year were profitable.