Pendulum to Swing Back Towards Active
July 9, 2019
Remy Blaire: Welcome to Asset TV. This is your Active Management Masterclass. Active Management incorporates the human element to actively manage a portfolio. The human element may be a single manager, co-managers or a team of managers. Active managers may rely on analytical research and forecast as well as their own judgment and experience in making investment decisions. I'm joined by Alex Ely, CIO Small/Mid Cap growth equity at Macquarie Investment Management, and Michael Kagan, Managing Director and Portfolio Manager at ClearBridge investments. Gentlemen, thank you so much for joining me for today's Masterclass.
Alex Ely: Thank you.
Michael Kagan: Thank you for having me.
Remy Blaire: Well, first and foremost, when it comes to active management, it does seek to produce better returns versus passively managed products. But when it comes to the active management space, I want to talk about what we're seeing in the market environment that's important whether we're talking about any financial investment. So first and foremost, can you tell me your perspective on the current investment climate?
Michael Kagan: So we've had a reminder in the last couple of quarters that the market is a little bit more volatile than historically. And, so it happened partly because there's a slowing in the economy in the world. So, China's bumpy, Europe is weak and may be in a recession, and then United States industrial economy is on the soft side. And then on top of that, we had a Fed that was raising rates last year and then now is in neutral and maybe about to go in lower rates. We had an inverted yield curve, which is often a signal a year or a year and a half in advance that you could have a recession. And then you have the trade frictions. So, we have a president who has discovered that tariffs are a weapon that he can use to go and get other countries to go and hopefully do what he wants. And so that's caused a flurry of pressure on the stock market.
Michael Kagan: So we've had both up and down. And then also in the backdrop is we're 10 years into an economic recovery. So, we may be due for a recession just from old age. And we also have the stock market that at least on Warren Buffet's measure is the second most expensive that's ever been.
Remy Blaire: And Alex, what's your perspective, given everything we're seeing in terms of fundamentals, as well as geopolitics?
Alex Ely: Sure. Well we have a different perspective. What we see is that there's massive disruptions that are technologically induced, that are making foundational changes to major industries that's creating massive investment opportunities all around us. So, whether it be banking or currency or all of our food or social interaction or social relationships, they're all changing right now in a massive way. And it's because of technology, it's because of the phone, and we'll continue to see a lot more of that. So, while we look at macro issues, we think that there are minor in the backdrop to what the real changes will be.
Alex Ely: As for the global outlook, we look globally, but US is the best place to invest. This is where the innovation is. This is where the new things are happening, this is where the great ideas come from, and it's because we're all a bunch of cowboys. We're willing to take risks, we're willing to do things and willing to take chances. And that's why we focus mostly on the US and the massive disruptions that we see.
Remy Blaire: And it's interesting you brought up that point of technology because the way that we all get our information as well as news, it's affected by technology and our smartphones. But Mike, how does an equity manager, especially in the active equity manager, assess short term risks? I know that you highlighted a current trade attentions and how you're watching that. But on a regular basis, how do you assess these risks?
Michael Kagan: So when we see something that's short term, that's usually just something that you trade against. So, for example, when we saw the Mexican tariff announcement, we really felt that it would be so disruptive to the US economy that it was more likely to be a bargaining position rather than something that was actually going to get implemented. And so, in that type of situation, if the market goes down, that's an opportunity to buy. If the market goes up, then it's an opportunity to sell. And we look at sentiment indicators to go and helping guide us on that. And in particular, we look at the breadth of the eighth market advance or the narrowness.
Michael Kagan: And, so for example, when the Mexican news came out, the market came under pressure and then there was a day when 80% of the stocks in the market were down. And that was an indication to us that there was liquidation selling. And that was the point where we started to go and buy. And we identified some names that had come under a lot of pressure in the last couple of weeks that we thought there were opportunities in that we'd had on our buy list. Those were the names we added too.
Remy Blaire: And Alex, I would like to get your perspective as well. How do you assess short term risk?
Alex Ely: We look at short term risks but what we believe is, as I mentioned in respect to those themes are disruptions that we see that are unlikely to get unseated by minor macro events. So, I'll give you a quick example. My mom will go to a teller and cash checks and buy a money order, and my son will Venmo money to all of his friends and just take pictures of checks. So that won't change if we don't do a deal with China or something like that. So, we try not to manage too much around the short-term, but look to the longer term where the world is going to change over the next two to three years. When those names do come in on, on concerns that, as Mike said, are more short term, we'll opportunistically buy them. And if things get really extended and move very quickly, we'll trim names. But in general, we're sticking with the same themes and believing in them for the long run.
Remy Blaire: Mm-hmm (affirmative). And Alex, I also want to know why should investors be reconsidering active at this moment in time?
Alex Ely: When I talk about these disruptions, the massive changes that are happening are significant. I'm not the only one that sees them. There's lots of people that do. Nearly two thirds of small cap managers are outperforming over the last one year, three year, five year, 10 year. And it's because they can see the companies that are really growing that are really changing the world and get positioned in front of them. And that's a massive amount of Alpha that's created far and above what the indexes are doing. Passive investing typically works during times where there's macro concern, like '08, like '09, like 2010 where the market is trading off, how big the next quantitative easing is, or whether we're going to nationalize the banks. That's not the world that we're in today. Where we are now is where fundamentals matter. So that gives active managers and edge because that's what we're studying. We're studying the fundamentals and the opportunities that we see in front of us. So that's why active should be on a great run, similar to the way we were in the fifties and sixties and the eighties and nineties.
Remy Blaire: And both of you have lived through different market cycles as well as through bull markets and bear markets. So, Alex, starting with you, can you tell me a little bit about your investment philosophy?
Alex Ely: Sure. The investment philosophy is to understand where we are in the macro set up, and understand where we are for the markets for the longer term and then identify what we think our major demand trends, or major disruptions that are occurring, and identify them early. Then we want to own the leaders of those trends and hold them for the long run and allow those fundamentals to play out. Allow it to get at that great earnings growth that may not be there today because maybe the company's not even earning money today, but earning over the long run is going to add lots of cash flow, lots of earnings and so forth. So that's what we're after.
Remy Blaire: And Mike, what about yourself? What is your investment philosophy?
Michael Kagan: The appreciation portfolio is a large cap core product whose goal is to beat the market over a market cycle, but to do it with materially less risk. And when we think about risk, we think most of all about downside capture and that would be, say the market's down 10% and we're down 8%, that would be an 80% capture, and that's what we look for. So, we want to protect on the downside. If you look at the history of our portfolio, what you find is that when the market is up 13% in a year or less, we outperform. And only when the market is up an awful lot do we underperform. But over a cycle we outperform by a little bit and we do it with a lot less risk. We do it by owning large cap, high quality companies. Companies that Warren Buffet would tell you have a moat around them. So, strong balance sheets, strong management teams, high margins and earnings that are very robust in a recession.
Remy Blaire: And Mike and Alex, we've a set the stage for this discussion on active management. And you just mentioned the word risk. So generally, can you tell us how active management can be beneficial during especially volatile periods of time?
Michael Kagan: So a passive fund, when the market goes down and say 55% as it did from the peak to the trough in 2007 to 2009, your stock, if you own a passive fund and it goes down 55%, you're down when the market's down. Our portfolio because it owns the types of companies whose earnings continued to be steady or even grow in a recession, so let's say a company like a PPG, which is a paint company, so volumes of paint don't grow an off a lot. They don't shrink an awful lot, but raw materials move around a lot. And to when a recession, the volumes go down a little bit. The raw materials go down a lot and their earnings per share growth actually accelerates. And so, PPG is a company that actually can go up even in a down market. And so, we tend to own those types of companies. Companies that have very strong balance sheets. They're the last companies that people sell when they get nervous and the first ones they buy when they begin to get a more committed to buying market.
Remy Blaire: That's very interesting, regarding the paint. But I do want to move on to you Alex, when it comes to active management and risk, you've been investing in small cap equities for almost two decades. So, is active management getting tougher and is it harder to outperform today than it was say a decade ago?
Alex Ely: A decade ago it was harder to be active because as I mentioned, those macro forces were dominating the tape. That's what was moving markets. As an example, in 2010 when they announced the size of the quantitative easing plan, energy and material names that had been terrible did very well with the prospect that deflation was off the table. So today it's a much better environment for active managers to outperform. And it's because of the fundamentally driven trends that we see that are out there.
Remy Blaire: And Mike, going back to you regarding management, how can active managers protect on the downside during turbulent periods compared to risks that investors in passive strategies are exposed to?
Michael Kagan: So I made reference to PPG and the paint companies and companies that have sustainable earnings in the downturn. Another thing you want to watch out for are companies that need an awful lot of cash to feed their business model. So, for example, I love Netflix. It's an amazing company, amazing business model, but they need $3.6 billion a year to go and feed the beast to develop the new content. And so, when the market gets messy, they're very volatile. As an example of the market was down 19% in the fourth quarter, they were down to 70. So, it's a very volatile stock. So, when you get to a point where you think that the market is going to be risky and we're late in the investment cycle. We've had an inversion of the yield curve. Now is the time to begin to be careful about your portfolio. Now at the time to batten down the hatches. And so, a name like Netflix that early on in an economic recovery, is something you probably do want to own because it's going to be a power house, at this point is very dangerous and you want to avoid.
Remy Blaire: And I do want to get your take on what we're seeing in terms of disruptors though, later on in the conversation as well. But, he just mentioned Netflix and that is a new space. But with technology comes a lot of disruption and a lot of industries do you get disrupted as a result. So, what do you make of what we're seeing in terms of where the disruptors are coming from? And why do you think it's in the US?
Alex Ely: Sure. Well, in respect to what Mike was saying about Netflix, a streaming media is a disruption where we still have 180 million cable stubs in the country and the percentage of college kids that are coming out and getting cable is near 0% because they're using a streaming because it's a better, cheaper, faster way. When I talk about disruption, that's what we're looking for, is a better way of doing things that won't get upset by those minor macro issues that'll happen. As a small cap manager, what's great is that we're trying to get at these early. So, I would agree with Mike in respect that once something is mature and much larger like Netflix is, your edge is missing. Whereas when you're a small capping and you're early on, that's where you can really put significant points up there. So, we see disruption in a lot of different areas.
Alex Ely: I mentioned banking before. The reason that it's happening with banking today is we just got smart phones 10 years ago. We just got good coverage five, six years ago. And you need constant coverage in order to have digital currency or mobile banking. And we have it today. We're still moving to unlimited data plans today. Just on that one point, in the most recent quarter Apple reported Apple Pay transactions we're up 100% year-on-year to 11 billion transactions. So, we're early on. It's just happening today and it's a very exciting time. So just in that one area, I've taken all currency, all banking and move them onto the phone, and those are massive markets with massive opportunities. And there's a variety of smaller mid cap size companies that are benefiting from that. So that's one area of disruption.
Remy Blaire: And it's interesting when we talk about active management, the term passive also gets mentioned as well. But a lot of people watching this master class, they may be a new to the field in terms of advising. And there are a lot of myths out there surrounding active management. So, what are some of the myths that you'd like to address?
Alex Ely: Well, I think most of the myths are that there's more risk involved with active and that perhaps it's more emotionally driven, or that it's much more expensive or something like that. Active managers can beat passive managers by a lot. Just in the funds that we're running, we're beating the S&P by over 35% in the last two years. So, massive amounts of Alpha are available to investors out there if they're smart, and they pick great strategies that can beat the index, which is stagnant and invested in a lot of companies that aren't moving, aren't growing, and don't have the same opportunities that active managers would be able to see. So, in this set up that we're looking at today, lots of opportunities ahead for active. I think that the pendulum has swung way too far towards passive investment. This is typically what happens in the investment world is people chase past returns, and we should see that swing back towards active over the next decade.
Remy Blaire: And Alex, when it comes to some of the benefits of active management, some you've already mentioned, over the past three years you've significantly outperform the index. So, what do you attribute this to?
Alex Ely: It's the disruptions. It's basically having a view of the world where you're trying to understand where the big industries are being upended, where there're better, cheaper, faster ways of doing things. I mentioned a couple like mobile banking and digital currency, but there's also areas like biotechnology where we're using a genetic testing, and we're individualizing medicine, which makes massive changes. We're seeing changes in terms of how people find social relationships, even interacting, when you look at all social networking. And again, all of these companies are US companies that are dominating these spaces. So, we think that this will continue for a variety of reasons. I think we're very early on in terms of the whole world sharing all the information, education, content at the same time. And we're seeing it in real time and in terms of changes in these massive industries. And in essence, tech is being used as a weapon from one company versus another.
Alex Ely: Take a look at autonomous transportation systems. Whoever is able to achieve the software system for that first they win and they win a massive market by doing something like that. Or look at the accounting agencies that are accelerating spend on AI in order to replace accountants, in order to make their themselves have a better business model. All of these companies realize this and they're after it. And so, tech or in this case software is really the new capex of the future and provides a lot of opportunity for investors.
Remy Blaire: Well Alex, it's great to get your perspective on technology as well as some of the benefits as you mentioned. But Mike, when it comes to the benefits of active management, what is the value of fundamental bottom up research, and how does that guide active stock selection?
Michael Kagan: So the key with active management is to have company contact and to get an information edge. So, I'll give another negative example. But in September of 2017, I met with GE. And so, the bull case on GE at that time was that they were very depressed in earnings because their industrial business, their power business was cyclically depressed. And the thesis was that over the next couple of years that orders would pick up, merchants would pick up, earnings per share would explode, and the stock was very cheap on that basis. So, we met with the Head of Power and what he told us actually was it wasn't a cyclical problem. That was secular problem. That there was a major change in the technology that the technology was moving to an area that was more commoditized, where GE had a weaker market position, and that the earnings were going to come back.
Michael Kagan: Now this is public information, but because we were meeting up one on one with him, we were able to probe and to really understand the business. And that gave me the conviction that I needed to walk away from that stock, that the bull case was wrong. And so, we sold it at heck of a lot higher price than the stock is at right now. And so, the key is, for us at least, that we're a very large company. We have 140 odd billion dollars under management. We talk to companies all the time. Yesterday there was the announcement of the UTX Raytheon merger. We're decent sized shareholders of both of those. We've had long relationships with the companies, and we had a telephone conference calls with the chief managers at both companies in the last couple of days. And so, we're able to go and get insights because we have a contact with the management teams and that helps us guide our investment decisions.
Remy Blaire: And I think that also highlights how important the human element is when it comes to management. Now, Alex, I do want to continue this conversation, get your perspective as well. Are small caps growing more or less efficient? Most would think that inefficiency does erode over time, but what's your perspective?
Alex Ely: Small cap stay inefficient. There's a lot less people covering these companies. If you mentioned a GE or a Netflix, there's dozens of Wall Street analysts that are all over them, tweaking models and lots of people looking at them. And it's harder for larger cap managers to outperform as a result. Small cap managers, there's more discovery value, there's less analysts covering the company. And in general, it's just a lot easier to find a $2 billion name that can double versus a $200 billion name that can double. So those inefficiencies persist, that discovery value persists and that's what puts us in a unique spot.
Remy Blaire: And I do want to move on to some of the market trends that we're seeing right now. Now we can't deny where we are in terms of the cycle of the current US economies. So, Mike, starting with you, what qualities do you look for in equities during the late stages of an economic cycle?
Michael Kagan: You want to own those large cap, high quality companies. They offer liquidity. When people get nervous, those are the last names that they sell. And if they have to sell them, they don't have to punish the stocks in order to get out of them. You want to own companies that have great balance sheets and defensible business models and sustaining the earnings and cash flow in a downturn. So, as I say, it's just the types of stocks that are in my portfolio.
Remy Blaire: And Alex, we have been seeing a massive exodus from active to passive. So, do you think this is good or bad for investors?
Alex Ely: Well, again, talking my book as well, but I think it is bad for investors. I think that, they need to get active exposure to differentiate themselves from where the indexes are. When you're investing in the index is you're investing in a lot of companies that aren't particularly well run, and don't have the same kinds of opportunities that an active manager would be able to identify and put you in front of. So, I think it does hurt investors and I think they'll realize it as I mentioned, over the next decade and we should see things swing back to active management.
Remy Blaire: And if we look at the current landscape, we all know that people are paying attention to what's coming out from the Federal Reserve as well as geopolitical comments, and of course, keeping an eye on fundamentals. But since both of you got into the space, what do you think has changed in terms of the landscape and what active managers need to pay attention to?
Alex Ely: Well, when it comes to active managers, everybody looks at different things. All the strategies are different. Some people appreciate my macro inputs more. Certainly, the Fed is that the kind of thing that could cut off of the economy or create a recession. So, it's something that you have to watch. There are much more communicative than they used to be. So, there's more insights like that, but for us, it's much more about understanding how major industries are changing. The consumer confidence levels, how confident people are in order to get a new job or their ability to lead their old job, or their freedom in terms of their confidence in moving into different areas of the country. Those are the kinds of things that we look for when it comes to just understanding that we're in an okay environment to continue to invest. As soon as main street is up ended, where, like my kids start changing their spending patterns because of our Chinese trade war or something like that, that's when I would get concerned. But for now, it's, it's not as concerning to us. We just see a lot of opportunity ahead.
Remy Blaire: And Mike, what about yourself?
Michael Kagan: I think that the increasing use of passive in the market has become much more efficient over my career. So, when I started in the late 1980s at Fidelity, you could call up a pretty large cap company and you could get information that might be different in and might give you an advantage. Nowadays it's much, much harder. You have to work much harder for it. And so, we do a lot of the same stuff that Alex does in terms of looking for big trends. So as an example, one of the things that's really helped the portfolio over the last six years is that we identified six years ago that there was going to be a massive expansion in the cloud business. And so, we have had big positions in the public cloud vendors.
Michael Kagan: Microsoft is the biggest name in the portfolio. And basically, there's a massive shift going on in the way that software is developed. It used to be big monolithic clubs that were difficult to debug, and it was easy to make errors and difficult to find errors. Now, programs are more agile. They're easier to change and then also the cloud offers by-the-second timesharing. And so, if you're Netflix and you have a ton of demand at 7:30 in the evening and very little at 12 in the afternoon, you only have to pay for the resources when you use them rather than all day. And so, we look forward a big term trends, big time trends, and tend to companies for a long period of time.
Remy Blaire: And we've been highlighting the tech sector, especially the disruptors, whether we're talking about Netflix or the Gig economy, 5G or AI. But how do you make sense of a lot of the newcomers to the market? For example, someone who might not be part of the millennial generation, they might not know what Slack is, for example, or what they do. And when it comes to the GIG economy, it's all about adoption and the generation you're talking to. For example, if you have someone who is in gen x, they may know how to use Uber or any of the ride sharing apps. But when it comes to factoring in how quickly these disruptors may grow or may not grow, how do you assess that landscape?
Alex Ely: Well, you definitely want to see what the younger people are doing. You're much more interested in what people in their 20s, teens, even [tweens 00:24:49] are doing in terms of adoption of technology. They're much quicker to pick it up. And so, I've been lucky. I have kids that are in their teens and 20s, and that puts me ... I ask them all the time about different things that are happening with them and the adoption rates for that. For us, we only invest in leaders of the trends. So that puts us in a better spot. We're not trying to own the third or fourth best player. We're trying to find what we think is the best company within each of these trends that we've identified. So that helps to reduce our risk and puts us in a better spot in terms of understanding where things are going.
Alex Ely: As you mentioned before, my team has been doing this for about two decades. So as a team, we're hyper-focused on growth, and what's you're always looking for is how big is the opportunity and then how clear is the leadership position? Mike mentioned Microsoft as an example. When Microsoft came out in '86, it was derided by large cap value guys that said, "Oh, it trades it 50 times earnings. It's a bubble. You don't want to invest in it." And what they missed out was how big that opportunity was. First PC penetration and then web services later on. And now the stock's up a 100,000% and now it's owned by those large cap value conservative managers because they now finally see how big the opportunity was, and the clear leadership position.
Alex Ely: So that's what we're constantly after and understanding that that trend will persist regardless of minor macro issues. So, if you have the crash in '87 or you have the 1991 S&L crisis, you don't say, "Well, let's get rid of the PC and bring back the calculator and the typewriter." You realize the value proposition, the better, cheaper, faster way of doing things that that company provides.
Remy Blaire: And Mike, what's your perspective on all of this?
Michael Kagan: We have awesome technology analysts. And so, when we have a name like a Slack, then we have people who were really up to speed on the technology and are able to go and make recommendations on it. And they have a lot of insights.Our analysts understand those nuances very, very well and so they help guide us.
Alex Ely: Mike has a great point. This is always a team effort when you're working with a particular strategy. You need people to be covering all these different companies and have a lot of experience in it and there's definitely a lot of advantage to having that.
Remy Blaire: And as we head into the end of this month, that means we'll be heading into the second half of 2019. And so far, we've seen so much happen in terms of the broader market as well as monetary policy fundamentals and the continued trade wars. But when it comes to lessons learned, when you look at your decades of experience, there may be people watching this master class right now, advisors looking for words of advice. So, what would you say to them when it comes to your space?
Alex Ely: What I would say is stay the course. I've tried to predict corrections and bear markets all the time. I find it really impossible to do and that you're missing the point of investing. You have to be investing for the long-run. You have to be thinking of the long-run. Often, it's great to have a financial advisor work with you in terms of being able to deal with the volatility. As an example, in the fourth quarter of 2018, we saw the largest draw down of active equity funds in a decade. And it's because a lot of those people don't have an adviser or don't have someone that they work with in order to allow them to ride out the volatility and ride out the downturns over time. You're just not going to be able to call when to sell and when to buy over and over and over again. You want to stick with a time-tested strategy that you believe in and hold through it throughout that period of time. We'll see different things that will happen, whether it be the Chinese trade war or information from the Fed. We have the elections next year. There'll be corrections, there'll be volatility. But if you really believe in a process of investment you can stick with it and beat the market by a lot.
Remy Blaire: And Mike, are there any lessons learned that you'd like to highlight?
Michael Kagan: Well, I'd say cycles don't repeat, but they do rhyme. And so, there were things that you see every cycle over and over again and things to watch for that can guide you in how you invest. I very much agree with Alex though that staying in the course is a critical thing, and it's one of the features of my strategy that because we protected the downside, it enables you to hold when things get bad because you know that we're going to protect you. I would say right now the thing though that's rhyming is when you have the Fed, when the yield curve inverts, that is a real warning sign. We are late in the economic cycle. We do have to be careful right now. And so, while you probably should be invested in the market, historically you get positive returns and good returns for the 14 or so months after an inversion. You also have to be more careful.
Remy Blaire: And as you said, staying the course is important. So, looking ahead, I want to get your perspective of Mike, Alex. And Alex starting with you, is there anything going on in the market right now that makes you feel more confident in active ahead?
Alex Ely: Again, I come back to technology-induced disruptions, or innovations. It's not always tech. As an example, we own companies that have higher quality food that are doing particularly well. And we've seen a huge shift in terms of appetites, no pun intended, for higher quality food situations. So, whether that be in your grocery store with organics are all natural foods, or whether it be a with restaurants. You can see it on the street during lunchtime. There's long lines in front of all natural food places and higher quality food places in general. So those are the kinds of disruptions and the innovations that we're seeing, make it a great time for active management. And so, we're positive going forward.
Remy Blaire: And Alex, before I move away from you and ask about Mike's Perspective going ahead, since you mentioned quality of food as well as disruption, we know there has been a lot of focus on meat alternatives recently, especially given us some of the companies that have gone public or are planning on going public. And we've also seen the bigger food conglomerates also buy out the smaller organic companies. But without naming any names, what do you make of what we're seeing in that space in terms of food and meat alternatives?
Alex Ely: Yeah, it's smart. There's definitely an appetite for a meat alternatives, particularly amongst people that are in a younger generations. And so, there's a lot of opportunity there, and there's definitely a lot of opportunities for the leaders. But food like that will end up being a competitive space. You'll see all of the major food conglomerates come out with different offerings that they have. So, it'll be interesting to watch, something to watch closely. But it is a competitive space that you'd have to be careful with. It's not something where you have a specific recipe that can't be replicated in some way. Your barrier to entry is tough. So, we like the space but we're not invested in meat alternatives.
Remy Blaire: Yes, indeed. It's interesting some of the signs that does go behind that and to also see the fast food companies diving in and trying to take a bite out of that burger.
Alex Ely: It is. We just can't help ourselves. Absolutely.
Remy Blaire: And Mike, I do want to move on and get your take on ESG. That's one area we haven't talked about yet, but as an active manager, do you implement ECG considerations into your investment process and how does that contribute to managing risk?
Michael Kagan: So ESG is one of the things that differentiates ClearBridge from other large cap managers. We integrate ESG intimately in our process. So, each analyst who follows a company, every company that they follow, they have an ESG rating on it, to environmental, social, and government until they have three ratings, and they're combining together, and it's a rating that's anywhere from B, which is [uninvestible 00:33:16]. And so, an example of something [uninvestible 00:33:17] would be say a defense company that makes weapons, or a tobacco company, that sells an addictive, a dangerous product, to a best in class company. So, somebody like say a Costco where, while they're interested in making profits, they also take care of their employees really well, and they sell really good quality products. And so, it's a company that makes you feel warm inside, and I think it's root of their success.
Michael Kagan: So ESG is integral to everything that we do. And even in our non-ESG portfolio, it colors what we do. We think of it as a quality aspect. If you look at the appreciation portfolio, on average our ratings are B, A, AA and AAA, where B is [uninvestible 00:34:04] and AAA is best in class. Our rating on average in appreciation is higher than AA. So, we really like those companies that are good actors on an ESG standpoint.
Remy Blaire: Now, Mike, if you could tell me more about how ESG contributes to risk management.
Michael Kagan: So the ESG process forces you to go and focus on both the good, and the bad things our companies are doing. as an ESG investor, when you're looking at those types of things, it brings them to the fore. And so, you can't just brush them aside. And so, I think it helps risk control in our products because we're thinking about, is the company behaving well? We're sensitive to those, more sensitive to those issues than we might otherwise be.
Remy Blaire: And Mike, I'm moving on to what we're seeing right now. We are in the late stage in the economy. So, how do you prepare for this in a market cycle?
Michael Kagan: So there were certain groups late in the investment cycle that are higher-risk simply because you're late in the cycle. So, an example would be banks. Banks have credit risk. When you have a recession, credit becomes a real problem. Customers go bankrupt, you have losses. And so, banks tend to underperform. The other thing, it happens late in the cycle, you have this inverter curve where you have a very shallow curve. And because banks tend to borrow short and lend long, their net interest margins are very low. So, banks are a set of companies that tend to underperform, and you need to be careful to be underweight as you get late in the cycle.
Michael Kagan: On the other hand, property casualty insurance companies, nobody buys a property casualty insurance policy because they want to. They might cause they have to. So, property casualty insurance sales in a recession are very, very stable. And also, they invest in bonds on the other side of the balance sheet. And when rates go down, which happens in a recession, then the value of that portfolio goes up. So, they have gains. So basically, that's the ideal situation to own a property casualty insurance company. So, there's certain types of groups that just thrive in a recession, and you want to make sure that you own those, and there's certain groups, which have unusual risks, and want to be careful about those.
Remy Blaire: Well Mike, that does seem very logical. So, Alex, could you weigh in on that as well? What is your perspective?
Alex Ely: Sure. Just to echo Mike a little bit, it can be dead anywhere. Whether it's bad actors throughout the corporate landscape, anyone that has debt to cash flow levels that are too high, those are areas that you're going to be worried about. A cyclicality, you'll want to be moving away from. So, it can be semiconductors, it can be housing related names that you would be worried about. There's a lot of names that we don't invest in or don't have a lot of investment in, in energy, materials, industrials, they're very cyclical. So, you want to be underweight those kinds of areas because they really get hurt. And the highest valuation names are ones you want to be worried about as well because those higher valuations will compress as visibility shrinks in front of them. So, you're looking for more services-oriented names. You want to own more food names, more staples, ideas like that, names that can continue to do well despite a rockier economy.
Remy Blaire: And Mike, before we move away from ESG, we've seen an evolution in the space. And nowadays if you look at financial media, whether it's print or online or even broadcast television, we hear the term ESG a lot. So, in this space, how do you think it's evolved and where do you see it going?
Michael Kagan: Well, I think that the way that it used to be was that people had screens. So, I mentioned if you're a defense company, we can't own it. I think that this full integration and looking at companies and saying, "Okay, this company is good but could get better in this way. This company didn't use to engage with investors to talk about ESG issues and now they do." And so, companies are now sensitive to it. And it starting to change the behavior of companies. So, an example would be Walmart, which because of its labor relations probably still is [uninvestible 00:39:06], really focused on the environmental aspect. And so, it has solar panels on roofs. It's much more green. It's really changed the way that it operated. And so ESG is a force for good, and we think that can make the world better place.
Remy Blaire: And I'm sure we'll continue to see a lot of focus on the space as we move forward. And Alex, I also want to get your take on disruption again. So, if you could tell me a little bit about disruption in industries that you're currently monitoring.
Alex Ely: Sure. I mentioned that it's phone based. We really look as the smartphone and what's happening there as a new renaissance that's occurring. In essence, the renaissance was kick-started by the printing press. You had mass communication for the first time, and it created some of the greatest ideas ever like freedom and liberty and private property. It created a boom in terms of arts and theater and the different things that would happen there, and ideas that would make content more interesting. And we also saw even changes in financials were a monk invented double entry accounting, and made it so people could have collateral and build businesses and loans and so forth.
Alex Ely: We're seeing the same thing today. The movement against racism and sexism is accelerating because of the phone. And it's not just because of reporting and taking pictures. It's creating communities online, creating communities between people, and that's changing the world. We're creating ideas that I haven't even thought of that are just massive opportunities for society but also for companies as well. When it comes to the individual ones, I'll be talking about banking and currency and other things, but social change and a better world are ahead of us. And whether it be with ideas or new art ... We talked about streaming media before, it's the same thing. How many new shows can Amazon and Netflix create? There's been a massive boom of content and artistic creation, because of this new-found ability.
Alex Ely: I've got a son who was a musician. He made a song that he put on Spotify that has 150,000 hits in Taiwan. That sharing of art would never have occurred just five, six, seven years ago. So really exciting things that we're seeing, and it's within businesses, but it's within society as a whole. And that's what makes me so optimistic about the disruptions that we're seeing Ann.
Remy Blaire: And what do you think are the investing implications based on some of these observations you were talking about?
Alex Ely: A lot. I mentioned financials on double entry accounting. Think about what we're doing for charity and crowd funding and GoFundMe and all these different things that have risen out of this capability of putting the network together. So, we're seeing lots of changes. And in essence we're seeing ... Mike mentioned before that particularly younger people are looking for companies that are enacting change within their society. They want their companies, and the corporations that have so much power to be an actor for improvement in their world or in their society, and they're looking for that to happen. And that makes them more investible. So just right there, we're seeing a change in the way people look at those types of investments because of that.
Remy Blaire: And in today's masterclass, there has been a lot of a reference or analogies to what we're saying in active management. So, I do want to take a look at the story; Goldilocks and the three bears. Now when we take a look at the Goldilocks economy, we always hear about, "Is it too hot or too cold?" And we might forget about the actual story about a little girl who goes to the home of bears and tries porridge. Is it too hot, is it too cold and tries different chairs? But what do you see right now when we're looking at the economy and the Federal Reserve? And do you think we are in a new Goldilocks economy?
Alex Ely: I don't know that it's Goldilocks. I think the Fed, if anything, is a little restrictive right now, and the odds of there being a rate cut later in the year has increased, which is part of the reason for the short-term rally we've had over the last couple of weeks. So, I see us in an okay world, not great. When I talk about these different trends, it's really a smaller slice of the overall pie that I think is doing really well. If you were to talk about GE or General Motors or some of these mature companies, I wouldn't be as excited. I wouldn't be as pounding the table as I am in terms of the other opportunities that I see. So, I think that it's an okay environment. As Mike said, we are a long in the tooth in terms of the expansion. But that said, it can go on for a long time. Australia is in their 25th year of expansion in a similar type of setup. So, I don't think it's great, but I don't think it's bad either.
Remy Blaire: And Mike, what is your perspective?
Michael Kagan: I don't know that Goldilocks is the right analogy. I think that we have a bifurcated economy right now where the industrial economy is on the ropes a bit. On the other hand, the consumer is doing very well. And I guess on balance, you'd probably bet on the consumer. The consumer has a job right now. They're seeing excellent real wage growth. And if there's one thing we know about us consumers are they love to spend money. And so that gives us stability to the US economy. I think it's one of the reasons why of the developed nations, it's been the fastest grower for decades, and the leader. It's the strength in that consumer. And so, I watched with a little bit of trepidation that employment number that we had for May. And so, we need to watch that. So, I think that's the critical thing.
Michael Kagan: If the employment continues to be strong and then the economy will probably be okay, and we'll probably be able to go into bridge the issue that we have here with the industrial side of the economy. If we see further weakening on jobs, then I'm afraid we're in for a recession.
Remy Blaire: And now that we've gotten your perspective on what we're seeing in the economy and what you expect going forward, I do want to wrap up this discussion by talking about the future of active management. A lot has changed in the space, but what do you expect to see in the near-term?
Alex Ely: In the near term, I think that we'll continue to see flows out to passive. I think that active is still derided and not as understood as I think it could be. But I do think active will keep out performing. In the 90s, 70% of small cap managers outperformed their indexes. We're seeing similar types of things this year and over the past few years. So, I think active, we'll keep outperforming in a significant way over the near term.
Remy Blaire: And Mike, what about yourself? What do you expect to see going forward?
Michael Kagan: So I agree that the trend is certainly towards passive. On the other hand, we're already more than half of the market trading is passive trading. So, there's a reduction ad absurdum where you should get too much trading in passive, then the market can become a wildly inefficient because if everybody's trading passive, then when there are changes in the real value of companies, they're not being reflected because everybody's going and trading indexes. So, there's going to come a point where that's going to create tremendous opportunities for active managers. And we're a lot closer to that now than we were say 10 years ago.
Remy Blaire: And of course, this is a masterclass. So, I do want to get your closing remarks in terms of active management. If you had to tell a retail investor what active management is in a nutshell, starting with you, how would you describe it?
Alex Ely: Well, when it comes to active management, you're looking at tried and true professionals that are trying to enact a discipline process and trying to make money and create wealth for their clients in a diligent way. And if you're in a passive management, you're settling for mediocrity, is what you're doing. And if you can find good active managers that have a lot of experience in a stable team with a proven process and good past performance, typically that strong performance will continue. And that opportunity is there for you to make a significantly more than you would be making with just an index fund.
Remy Blaire: And Mike, what would you say?
Michael Kagan: And I agree. The key is to find a manager that has a repeatable process that offers you a different risk-reward combination than the market can give you. If you find the right active manager, you can do better than the market. And that's the key. If you own just the market, then your investment decision and stock market is just an asset allocation decision of, "How much money do I own in the market?" But there are better alternatives than that.
Remy Blaire: And since you mentioned some of the attributes of a good active manager, what would you say investors should be looking for when it comes to active management?
Alex Ely: Well, we're a concentrated investor. We only have about 40 names that we invest in at any particular period of time. And that means we have a lot of active share. So, active share is one of those things that you can look at in terms of how active is that particular manager relative to the index? So that's one of the things that you can look for. Another one would be to look at volatility. Mike mentioned downside capture, or you can look at upside capture. Each one is different, but what you're looking for is a differential that significant between the two so that maybe you are in line on downside, but significantly higher on upside capture. So those are things that you can look for as well. Stability of the team is very important. You want people that have worked together for a long period of time. So those are all things that are significant. And performance. Typically, the great managers of the future are the ones that have been good in the past. So, you're looking for that as well.
Remy Blaire: And Mike, do you have anything to add to that list?
Michael Kagan: Most of all, consistency of process and consistency of returns. And so, each strategy, when it tells you that it's going to do something, it needs to do it. So, if a strategy says it's going to protect on the downside, then look and see how it does in a quarter when the market's down a lot. If it says that it's going to outperform on the upside, then how does it do when the market goes up a lot? It needs to deliver on its promises.
Remy Blaire: And last but not least, since you mentioned consistency as well as performance, there's one word that gets thrown around a lot and that's volatility. And volatility could be good or bad, but it's not always black and whites. So how do you assess it and how do you describe volatility?
Alex Ely: A lot of people look at volatility like it's a bad word. And I've had people tell me in the past that volatility is the price that you pay for success, that equities are volatile, and they do move up and down. But on average, they offer far better returns than bonds do. Over the last 50 years, if you look at 20 year periods, equities outperform 100% of the time. And you need that risk and that volatility in your investments to deliver above average returns for your retirement. People are living longer. The average person lives to 78, but if you make it to 60, the average person lives to 83. So, if you're 55, 60 years old, you could easily have 30 more years to live. And I don't believe 2% or 3% is necessarily going to be enough for you to retire on, or to continue to live well on 30 years down the road. So, I don't really look at volatility as a bad word. I look at it as something that you have to endure in order to have higher returns over the long run.
Remy Blaire: And Mike, do you have anything to add to that?
Michael Kagan: Well, I'd say that volatility creates opportunities. So, what you want to do is when you see volatility, you need to decide, "Is it real? Is it short-term noise or is it more significant?" And then you also need to watch sentiment and to find out whether maybe the market's overdoing it. And so, if you have an opportunity when things are going down and everybody seems to be really bad, so for example day when 90% of the stocks in the market are down, that's often a good time to go and buy stocks. Similarly, you want to watch when volatility to the upside, when everybody's too euphoric and 90% of the stocks are going up, maybe that's the time to go and take a little bit of money off the table. So, volatility is opportunity.
Remy Blaire: Well gentlemen, thank you so much for your insight today and thanks for all your input into the active management space.
Michael Kagan: Thank you very much.
Alex Ely: Thanks Remy.
Remy Blaire: Thank you. And thank you for watching. This has been your active management masterclass from our studios in New York City. I'm Remy Blaire for Asset TV.