Winning at Active Management. Welhoelter Michael A.

for many managers to beat for several years. But inefficiencies in the pricing of stocks are timeless, and we believe that active equity management still works, and that the best managers can deliver excellent performance over the long term (Chapter 7). Active management is not dead.

      This book is a second installment to a volume that I authored in late 2006 with Lindsay McLelland, Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor, published by John Wiley & Sons in early 2007. A few years after the founding of Epoch Investment Partners in 2004, I wanted to share views on what we saw as crucial investment issues of the day, and relate insights from the perspective of the firm’s investment process. The factors that would lead to the global financial crisis had just started to surface, and while we weren’t prescient on every topic in the book, we got many of them right as evidenced in white papers Epoch published at the time. (For example, see “The Canary in the Coal Mine: Subprime Mortgages, Mortgage-Backed Securities and the U.S. Housing Bust” from April 2007, reprinted in Appendix A.) More important, Epoch’s strategies fared well in the markets that followed, so the firm and its clients came through the global financial crisis in good stead.

      A couple of years ago, I decided to write a second book. People that I talked with assumed it would take the form of a memoir about my 50 years in the investment industry. That idea had some appeal, as the markets of those years were varied and dynamic, and I have been “in the room” at critical junctures of market volatility with important and colorful people, and have plenty of stories and lessons to share.

      But I am not a historian – I am an investor, and as such I am much more oriented to the future than the past. Of course, history is often the best guide to the future, but the “present” that today’s investors are facing – which includes the recent unusual period of the global financial crisis, and how governments, corporations, and markets have contended with the world since – make the further past of my career seem less and less relevant going forward.

      Still, my experience has been pretty interesting, so I will share a bit. I joined the industry cavalcade in July 1965 at a mutual fund management firm, working as a research analyst initially and eventually a portfolio manager. I joined BEA Associates in New York, as a portfolio manager and partner of the firm, in July 1972. That November the Dow Jones Industrial Average closed above 1,000 for the first time. (The 1,000 mark on the Dow presented a challenging summit for equity investors: the average broke through 1,000 in intraday trading three times in early 1966, but did not end the day there.2) The firm’s staff numbered 11, and BEA managed less than $300 million in client assets – pretty small even in 44-year-old dollars. Not only was BEA a minor force in the market; the firm also had a weak balance sheet and at the beginning operated hand-to-mouth.

      Shortly after I joined the firm, there was a significant collapse in stock prices – from its peak in December 1972 through December 1974, the Dow dropped 44 percent.3 My timing in leaving a large firm for the entrepreneurial excitement of a startup could not have been worse: the resulting decrease in assets and management fees led to a few BEA staff (of whom I was one) having to forego cash compensation for several weeks. However, BEA was fortunate to have a strong culture – one based on personal integrity, the motivation for the work that lay ahead of us, and the drive to provide superior performance for our clients.

      There’s a saying in the stock market, which applies to life in general: Timing Is Everything. For BEA Associates, it was everything, and more. In 1974 Congress passed the Employee Retirement Income Security Act – ERISA – for the protection of employee pension funds, requiring employers to adequately fund them, and segregate the assets in formal pension plans. (The expanded requirements for recordkeeping, regulatory compliance and investment mandated by ERISA were so sweeping that those in the business jokingly called it the “Accountants, Lawyers and Money Managers Relief Act.”) The resulting flow of contributions from corporations to the pension funds they sponsored launched a new era for institutional asset management. The passage of ERISA was prompted by “the most glorious failure in the [automobile] business.” In 1963, after stumbling financially for many years – a strong postwar market for U.S. car sales notwithstanding – the Studebaker-Packard Company closed its plant in South Bend, Indiana. Workers aged 60 and over received their expected pensions, but younger workers received a fraction of what was promised or nothing at all. The shutdown helped advance a growing debate on pension reform into the national legislative arena, leading to the passage of ERISA in 1974.4

      The new regulations forced the financial analysis underlying pension funding to a higher level, and to meet some of that need, I was fortunate to co-author, with financial scholar Jack L. Treynor and fellow BEA partner Patrick J. Regan, The Financial Reality of Pension Funding Under ERISA, published by Dow Jones-Irwin in 1976. Our conclusions grabbed the attention of legislators, and I testified before a congressional committee that influenced later regulations on the viability of insuring pension plans via the Pension Benefit Guaranty Corporation (PBGC). My co-authors and I were concerned that under certain circumstances, the PBGC could go broke, and Congress did indeed repeal and amend the section known as CELI – Contingent Employment Liability Insurance.

      BEA expanded rapidly in the new era: by 1980 our managed assets had climbed to $2 billion, and the firm was recognized as a leader in U.S. institutional money management. In 1989, I became the CEO of BEA Associates, but continued to manage institutional portfolios. A year later the firm entered into a formal partnership with global bank Credit Suisse, although BEA Associates maintained its name until early 1999, when it became Credit Suisse Asset Management-Americas and I continued as the CEO. We then acquired Warburg Pincus Asset Management in spring 1999, at which point the fully built-out CSAM-Americas managed assets of nearly $60 billion. In 2000, Credit Suisse purchased the brokerage firm Donaldson, Lufkin & Jenrette, and its asset management arm also joined CSAM-Americas, bringing total assets to about $100 billion.

      Over the course of those 30 years, as BEA Associates grew from a startup to the cornerstone of a large global institutional firm with offices in New York, Tokyo, London, Zurich, and Sydney, I witnessed the full life cycle of an asset manager – from the diseases of infancy that infect and threaten all new companies, to the limitless potential of vibrant middle age, to the comfortable but sclerotic bureaucracy that constrains complex global firms that grow too large.

      Then in 2001, Credit Suisse’s corporate policies caused me to “retire”: the bank had a policy of “60 and out” for executives at my level. I was always aware that such a policy existed – I just didn’t think it would apply to me! Having no desire to retire, in March 2001 I joined Michael Steinberg, an excellent investor I had known for some time, and we formed Steinberg Priest Capital Management. The firm’s managed assets grew from $800 million to over $2 billion in three years, but the partners had differing ambitions and we disbanded the structure in 2004.

      But I still had a desire to build a firm of substance, and in 2004 three partners – Tim Taussig, David Pearl, and Phil Clark – and I started once again, creating Epoch Investment Partners with 11 employees and initial managed assets of $640 million. As of the end of 2015, less than 12 years after its founding, Epoch oversaw nearly $50 billion in long-only equity strategies, and employed over 100 people.

      So much for the memoir. In this book I have assembled a discussion that I hope will prove interesting and valuable to people in investment management – what’s happening today, and what the industry might look like in 5 or 10 years, both in the “investing business” (that is, the selection of securities and the managing of portfolios), as well as “the business of the investing business” (managing the many non-investment functions – product management and client services, and a firm’s information technology, operations, and compliance functions).

      To be successful, an investment firm must clear three hurdles – its clients must reap superior investment performance; its employees must find desirable long-term employment; and its owners must earn fair financial returns. In this book, I have tried to share what I believe to be the required and essential elements to achieve these goals. Two of these are timeless, while the third reflects the growing dominance of information technology in every aspect of today’s personal and business life.

      The

2

Jason Zweig, “The 11-Year Itch: Still Stuck at Dow 10000,” The Wall Street Journal, June 12, 2010.

3

S&P Dow Jones Indices. McGraw-Hill Financial. Accessed at: www.djaverages.com/?go=industrial-index-data.

4

Wooten, James A., “The Most Glorious Story of Failure in the Business”: The Studebaker-Packard Corporation and the Origins of ERISA. Buffalo Law Review, Vol. 49, p. 683, 2001. Available at SSRN: http://ssrn.com/abstract=290812 or http://dx.doi.org/10.2139/ssrn.290812.