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Winning at Active Management: The Essential Roles of Culture, Philosophy, and Technology



Winning at Active Management: The Essential Roles of Culture, Philosophy, and Technology

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Winning at Active Management conducts an in-depth examination of crucial issues facing the investment management industry, and will be a valuable resource for asset managers, institutional consultants, managers of pension and endowment funds, and advisers to individual investors. Bill Priest, Steve Bleiberg and Mike Welhoelter all experienced investment professionals, consider the challenges of managing portfolios through complex markets, as well as managing the cultural and technological complexities of the investment business.

The book’s initial section highlights the importance of culture within an investment firm – the characteristics of strong cultures, the imperatives of communication and support, and suggestions for leading firms through times of both adversity and prosperity.

It continues with a thorough discussion of active portfolio management for equities. The ongoing debate over active versus passive management is reviewed in detail, drawing on both financial theory and real-world investing results. The book also contrasts traditional methods of portfolio management, based on accounting metrics and price-earnings ratios, with Epoch Investment Partners’ philosophy of investing on free cash flow and appropriate capital allocation.

Winning at Active Management closes with an inquiry into the crucial and growing role of technology in investing. The authors assert that the most effective portfolio strategies result from neither pure fundamental nor quantitative methods, but instead from thoughtful combinations of analyst and portfolio manager experience and skill with the speed and breadth of quantitative analysis. The authors illustrate the point with an example of an innovative Epoch equity strategy based on economic logic and judgment, but enabled by information technology.

Winning at Active Management also offers important insights into selecting active managers – the market cycle factors that have held back many managers’ performance in recent years, and the difficulty of identifying those firms that truly possess investment skill. Drawing on behavioral economic theory and empirical research, the book makes a convincing case that many active investment managers can and do generate returns superior to those of the broad market.

Preface xi

Active Management is Not Dead Yet

Part I Culture

Chapter 1 Culture at The Core 3

The Original Organizational Culture: Command-and-Control 5

An Alternative Culture for Knowledge Businesses 8

The Partnership Culture Model 10

Justice and Fairness 17

Chapter 2 Culture in Investment Management 21

Values 22

Integrity 26

Trust 28

Culture and Clients 32

Firm Culture under Stress 34

Culture in Recruiting 35

Acquisitions 38

Evolution of Culture 41

Part II Philosophy and Methodology

Chapter 3 The Nature of Equity Returns 49

Linkages: The Real Economy and the Financial Economy 49

Components of Stock Returns 51

Price-Earnings Ratios 53

The Historical Makeup of Stock Returns 59

Chapter 4 The Great Investment Debate: Active or Passive Management? 63

The Debate Is Timeless 65

An Elegant Theory: The Capital Asset Pricing Model 66

Further Elegance: The Efficient Market Hypothesis 68

Reality Intrudes 69

The Problem with MPT 71

Chapter 5 A More Human Description of Investors and Markets: Behavioral Finance 73

Loss Aversion 74

Mental Accounting 75

Minimizing Regret 76

Overconfidence 77

Extrapolation and Reversal 78

Investor Behavior in Action 78

MPT Still Lives 80

Chapter 6 Active Versus Passive Management: The Empirical Case 85

Market Regimes 87

Correlation and Dispersion 87

Company Quality 89

The Weight of Cash 90

Luck versus Skill 91

Investors Voting with Their Dollars 96

Chapter 7 The Case for Active Management 101

April 2015: Investment Giants Square Off in New York City 101

An Active-Passive Equilibrium 103

The Case for Active Management 105

Chapter 8 Debates On Active Managers’ Styles and Methods 109

Manager Style 110

Free Cash Flow Is the Measure of Value 112

Depreciation 113

Accruals 114

Research and Development Costs 118

The CFO Perspective 120

Chapter 9 The Jump from Company Earnings to Stock Prices 125

Flaws in Traditional Valuation Measures 125

Accounting versus Finance: A Case Study 128

Chapter 10 Epoch’s Investment Philosophy 133

The Starting Point: Generating Free Cash Flow 134

Choosing to Reinvest 135

Capital Investment: Returns and Capital Costs 136

Once More: Cash Flow-Based Measures Are Superior 139

Trends in Capital Allocation 142

Dividends 143

Share Repurchases 145

Debt Buydowns 150

Capital Allocation: What’s the Right Mix? 151

Part III Technology

Chapter 11 High-Speed Technology 159

Information Technology: Three Relentless Forces 162

Chapter 12 Technology in Investing 171

Information at Work 172

Order from Chaos: Applying Scientific Frameworks 172

Computers to the Rescue 174

A Virtuous Circle 176

Expansion of Index Funds 177

Betting Against the CAPM 177

Concurrent Developments 179

The Spread of Quant 181

Computing and Data, Neck and Neck 181

Big Data—Beyond Bloomberg 183

Artificial Intelligence 187

Chapter 13 The Epoch Core Model 191

Factors in the Epoch Core Model 192

Results of the Epoch Core Model 196

Chapter 14 Racing with The Machine 201

Investing Is Too Important for Robots Alone 201

Racing with the Machine 202

Seeking High Return on Capital 204

A More Practical Study 206

Is Persistence Contradictory? 208

An ROIC Strategy 211

The Value of Judgment 214

Epilogue 219

Appendix A: Selected Articles and White Papers of Epoch Investment Partners 223

Appendix B: Financial Asset Valuation 273

Appendix C: Feathered Feast: A Case 285

Acknowledgements 295

About the Authors 297

Index 299