Episode #116: “Without a Quant Risk Model, I’d Argue an Investment Manager Is Completely Blind”
Guest: Sarah Ketterer. Sarah is the Chief Executive Officer at Causeway Capital, Portfolio Manager for the firm’s Fundamental and Absolute Returns strategies, and is responsible for investment research across all sectors. She is a member of the Operating and Strategic Planning Committees. Sarah co-founded the firm in June 2001.
Date Recorded: 7/30/18
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Summary: In Episode 116, we welcome entrepreneur, CEO, and fund manager, Sarah Ketterer. Meb dives right in, asking about a quote on Causeway’s website which references how the shop blends fundamental and quant analysis. Sarah gives us her approach, which details how the fundamental and quant approaches work together, supporting one another.
Meb pushes for more details. What’s Causeway’s actual process? Does it begin with a quant screen then an analyst takes over, or the other way around?
Sarah tells us it depends on the client. She provides more details, but her feelings about the importance of a quant approach really comes through when she tells us “without a quant risk model, I’d argue an investment manager is completely blind”.
Next, Meb brings up value, and asks what role it plays in Sarah’s approach, and how she sees value today.
Sarah tell us that every strategy Causeway manages has a value emphasis to some degree. The more fundamental, the heavier the value exposure. And the quant-focused funds also have value, but those use momentum as well. This dovetails into a discussion of how not all clients want to sit through deep value cycles. They want returns now, not on a rolling 3-5-year basis. But a great value manager has to think in that time frame. Sarah notes how investors have to be patient with a value approach, yet human nature is not inherently patient.
This bleeds into a discussion of cheap countries and career risk, and the gap between value and growth – Sarah tells us this gap has reached extreme levels. Meb asks about the opportunities she’s seeing. Sarah notes how the opportunities depend on the amount of risk you want to take. For instance, she can find you a good Turkish bank right now, but do you want that level of risk exposure?
There’s way more in this episode – some opportunistic finds in Britain… Why Sarah is “wildly bullish” on China… Sarah’s view on the biggest mistakes investors make regarding risk… And, of course, her most memorable trade.
All this and more in Episode 116.
Links from the Episode:
- 0:50 – Welcome and explanation of what Causeway does
- 3:01 – Causeway’s process for creating portfolios
- 7:41 – What is their investing style
- 7:46 – “The Compelling Case for Value” – Causeway Capital
- 10:32 – How Causeway minimizes risk
- 13:40 – What’s behind the value/growth gap, and what looks good now
- 20:40 – Best and worst places for investment today
- 20:54 – Adventure Capitalist: The Ultimate Road Trip – Rogers
- 20:56 – Investment Biker: Around the World with Jim Rogers – Rogers
- 21:14 – Where to Invest $10,000 Right Now – Bloomberg
- 24:42 – General thoughts on China
- 24:48 – “Adventures in China A Shares” – Causeway Capital
- 27:47 – Why Sarah prefers to have people on the ground in China vs investing through indexes
- 30:00 – Causeway’s Risk Lens
- 35:39 – The biggest mistakes that investors make in regards to risk
- 38:22 – An overview of Girls who Invest
- 42:18 – Most memorable investment
- 43:55 – Ramping up an investment business
- 46:10 – How to follow Sarah: Causeway Capital website, LinkedIn
Transcript of Episode 116:
Welcome Message: Welcome to the Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the Co-Founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Hello, podcast listeners. Summertime episode. Today we have a fantastic show for you with the CEO of Causeway Capital, a $58-billion investment management shop right down the road here in Los Angeles. She’s also the group’s portfolio manager, responsible for their fundamental and absolute return strategies. On top of that, she heads up Causeway’s investment research across all sectors. We’re thrilled to have her on. Welcome the show, Sarah Ketterer.
Sarah: Thank you for having me.
Meb: So, Sarah, let’s jump right in. Jeff and I were preparing for this episode. We’re flipping through the website. There’s a quote on there that reads, “Causeway manages equities globally in form of our fusion of fundamental and quantitative analysis. This dual perspective in a collaborative environment gives us a knowledge advantage that helps us build portfolios and manage risk for clients.” That’s music to my ears. So why don’t you unpack this a little bit for us, maybe talk a bit about y’all’s framework investing, and maybe talk a little bit about combining fundamental and quant analysis.
Sarah: Gladly. We began our firm in 2001. And prior to that, the co-founder of Causeway, our firm’s president, Harry Hartford, and I had schemed about how would we, if we had our chance, design what we thought was gonna be the most effective investment manager of equities that we can envision.
And at the time, we were working on this in the late 1990s, right in the heart of the tech bubble, we had the opportunity to work with some really gifted and talented quant specialists. And we figured out how we could use a multi-factor risk model, which is just a risk measurement tool, but it’s all statistically based to help us improve our investment portfolio, not just the screens we were using but actually the weighting of the stocks in the portfolio and the timing of the buys and the sells. It was like discovering the cure to cancer. It was the most exciting thing you could imagine.
And since then, in the last 17 plus years, we’ve built on that process 18 years and made it much more sophisticated so that everything we do fundamentally has quantitative support. And then the arrows go the other way. Our fundamental research supports all of our quantitative research.
Meb: And so maybe talk a little bit about that process to me. I mean, I know you have both fundamental and absolute return strategies. Is it something where you say, “All right, we’re gonna have a bunch of quant screens, and then we’re gonna sick all of our fundamental analyst on it then.” Or is it the analysts are out there on the field uncovering ideas and then we say, “Okay, you’re only allowed to buy this if XYZ.” What’s kind of the process?
Sarah: The process somewhat entirely depends on the actual portfolio and what the mandate is. We have some clients who want a bottom-up, fundamentally-researched portfolio. And they’re delighted to have the quant as both the screening tool and the risk management tool that’s embedded in it. And then there are other clients who want, for example, our primary strategy we use at emerging markets is all quantitative, and those clients deliberately chose a very broad portfolio, many more holdings than we have fundamentally.
So quant, think of a quant portfolio as many holdings. So instead of 50, there might be 150 stocks, and each one of them is designed to deliver incremental amount of alphas that all adds up to significant amount of outperformance. It somewhat depends on the mandate, how we emphasize the quant. But for the clients who hired us, for example, our largest mutual fund is international equity, there are 30 on investment staff, 23 of whom are fundamentally-oriented. And we travel all over the world and meet with these companies and try to read the body language, that 80% of communication that’s nonverbal, and go back and take more notes and create valuation models and convince our colleagues these are great companies and the price is right.
And then all of that process is then we’re seeing by quant because our quant colleagues create an analyst revision score. So they actually measure the efficacy of the sell-side analysts who are out there constantly grading the companies we’re contemplating investing in. When those self-analysis scores begin to reach a floor, and they’re no longer falling…because we’d like to buy stocks when they’re really out of favour.
Think about traditional value investing is one of the psychologically most difficult things there is to do. Our quant colleagues, who are sitting right with us on the same floor, the same office in Los Angeles, are helping us a lot with timing and how to organise the research so that we put a lot of time and effort into those stocks that have some of the best lowest risk scores. And in portfolio construction then, our emphasis is on highest risk-adjusted return stocks. Because you could go out and just find fantastic companies and with supposedly huge upside potential. But the problem would be that they could all end up being very closely correlated in terms of their performance, which means you’re aggregating risks. And the big sin is not knowing it.
So to your point, Meb, a while ago, without quant, how in the world does anybody know what risks they’re taking? Where companies are listed, in what countries, in what sectors or industries is only just a small piece of the puzzle. Without a quant risk model, I’d argue an investment manager is completely blind.
From a bottom-up perspective, this idea that if our portfolios are, fundamentally, we buy stocks based on risk-adjusted return. So our highest risk-adjusted return stock, for example, could be in Japan in transportation. And we have the portfolio managers, we’ve had six of them assigned to different sectors globally, and they’ll make a decision if their stock happens to be the highest risk-adjusted return stock, where they and the people in their sector area, they determined the return, and then our quant colleagues figured out the risk.
The risk-adjusted return is what we’re aiming for. We wanna have a portfolio with the stocks that have the greatest amount of return for every unit of risk, or think about it in terms of Sharpe ratio. And we’re not really interested in tracking error, fundamentally, so we could end up holding a portfolio that was very, very different from any index or any passive strategy ETF that one might go out and buy.
Meb: And we talked a lot about that. I mean, you kind of have to. I mean, we’re in a world where the market cap-weighted indexes are quickly becoming close to zero on fees that we say a lot of times, “What you really want in a manager, you want them to be concentrated.” It could be different, but meaning concentrated and active enough for it to actually make a difference. There’s so many of these closet indexers that still charge high fees but end up looking just like the broad indexes. So what you’re talking about… And we used to say weird and different, but it doesn’t have to be weird. But what you’re talking about I think is hugely important.
So talk to me a little bit about that process. I mean, we were flipping through, watching a webinar, you guys did recently called The Compelling Case for Value. And so maybe talk a little bit about your style. Would you guys consider yourselves to be pure value investors? Are you more kind of GARP-ish? And what has you particularly interested in value kind of right now?
Sarah: All the strategies we manage, whether they’re international, global, or emerging markets, or any combination thereof has a value emphasis. And the more fundamental the strategy of Causeway, the more heavy value emphasis it has. And the more quant strategy we have, we have an emerging market mutual fund as well as the international small cap that are primarily managed quantitatively, they also have a value emphasis, but they use other factors including momentum, for example.
So I would call them less emphasis value. But they’re not growth funds either. They’re just not as fanatical as what we do fundamentally. And one of the reasons why we chose to do this is not all of our clients want deep value cycles. Post-2008 investors have become very skittish. And they’re delighted that central banks have quintupled their balance sheets and there’s a lot of money looking for home in assets, but they’re still nervous, and their time frames are short, and they want the return to now, like in six months, not in a rolling three to five-year basis.
But a great value manager has to think on a rolling three to five-year basis because that’s where the opportunity is. And, frankly, I think that’s where we’ll always be, a little further out than the investment horizon of the crowd. That’s one of the reasons why we’re such devout value investors is because it works.
Prior to establishing Causeway, several of my teammates and I were together at a former firm, and we were value investors then. And in our webinar, one of our exhibits shows this rolling three-year performance of value. And it’s even long-term, or short-term, any period you wanna look at value, it may not always be delivering, but it does over any reasonably longer period. And from the early days of the indices in the early ’80s, it produced fantastic numbers. But you have to be patient. Human nature is definitely not to be patient.
Meb: We often say, when we’re looking at global valuations, we used to have a presentation that we were giving for many years, and the left side of the chart was a list of a bunch of cheap countries, and we would call the list, instead of the title being Global Valuations, it would be called Career Risk. Because for a lot of people, you know, the challenge…the value is you buy those names, they do well, you get a pat on the back. That’s what you’re expected to do. They do poorly, and you say, “Why in God’s name do you own stocks in Brazil,” or wherever they may be. And you’re fired and shown the door. Because, going back to the earlier comment, you really have to be different to generate excess returns. But for a lot of people, that’s tough.
All right. Well, talk to me a little bit about are there any places in the world, whether it’s countries, or sectors, or even individual securities, anything you wanna highlight where you guys are seeing particular interesting value today?
Sarah: I wanna just pick up on a comment you made is…we don’t peddle in career risk. The only reason I think we, in addition, delivering alpha, even though isn’t always as consistent as we would like, I think the vast majority of our clients, and we have over 150 of them, they chose us because there is no career risk here. We’re obsessed about diversification, about lowering portfolio risk, and ensuring that if something goes wrong at one part of the portfolio, it’ll probably go right in the other part. And, again, it really can’t be done without a risk model.
And the brains behind our risk model are our seven quant colleagues here. And some of them are PhD holders, and they’re very math oriented. And at Causeway, they happen also to be sociable and culturally good fits and people you’d want to spend time with, which is all a huge plus. But they’re the ones who helped us through all these statistical studies of understanding where the global markets are today.
And much of this research was particularly compelling through May and June of this year that the valuation gap between value stocks and growth stocks is measured by the standard indices both in the U.S. and outside the U.S. had reached extreme levels not seen since just before the global financial crisis. And we thought those were extreme from 2006. And that was one of the most encouraging pieces of research I’ve seen in a while that we’ve developed internally. Because we had hired to buck the trend, to stick with our conviction, to take an investment thesis on a company. And then assuming it hasn’t…the company is delivering, and their management is executing, and they’re cutting costs, and we’re structuring whatever went wrong in their business, we have to buy what others are still selling the stock.
So to have quant, as they’ve done in the past, support us in this process by showing us these very massive valuation gaps that are precursors to the turn when value begins to outperform versus growth and to show us how disconnected or uncorrelated the value strategy is globally with economic cycles as well as market cycles, and that we don’t have to wait for some sort of nascent economic recovery. The value can do well now, today, soon to be August, 2018. We don’t have to wait.
And that kind of information, we’ve sent it to clients. We’ve gone on the road and talked about it. Our clients are, they’re reassured. And we as a team are reassured. And that allows us to then have even more conviction when it comes to the even deeper value stocks that we hold.
Meb: Well, it sounds like, one, you have good clients and, two, sociable quants. All the quants here in my office we keep in the basement. So they’re allowed out on Wednesdays and Sundays, but that’s it. Otherwise, we keep them in the dark. I can say that. I’m a quant. So I totally agree with you on kind of this gap.
Two quick kind of extensions to kind of what you’re talking about, the first being is the gap do you think simply because there’s a lot of cheap stocks out there, or is it because there’s a lot of expensive stocks out there, or is it both? As far as kind of some of the spreads you’re seeing, are you seeing tons of opportunities or not that many opportunities but everything is expensive? And then, two, you can feel free to extend that into where in the world might be particularly interesting right now?
Sarah: I have a hard time on an absolute basis saying as a particular multiple, we can sort of back into it, interest rates. But that’s to say that there are many cheap stocks on average across all sectors globally. My colleagues and I would argue that the lower interest rates went in this post-global financial crisis period, especially the seven years of zero in the U.S. and when the long bonds went negative overseas. That meant discount rates or the rate you used to discount the cash, the stocks that generate over its life, which is effectively what it’s supposed to be worth. Those discount rates fell.
So the valuation just went off. Even if companies didn’t deliver greater earnings, they just got a bump up in multiple. That just meant that cheap wasn’t sort of absolute basis as cheap as we’d seen historically. But on the expensive side of your question, that was the eye-popping part. Because tech became 25% plus of the S&P 500 and another 28% of the emerging market index. And it’s only a paltry, like 6.5% of the international index. So you’re almost talking apples and oranges. And the tech valuations plus discretionary with the likes of Amazon, just unbelievable concentration of investor interest.
Anyway, I’m sure you’ve spent time on this in prior podcasts, but a lot of that they had plenty to do with the extenuating valuations, not just in P/E multiples and the price to book and paltry dividend yields and some very aggressive projections on return on equity. You’re willing to pay for something if you’re gonna get something for it. And supposedly, these companies would continue, these leading growth stocks, continue to generate ever-expanding operating profit margins and ever larger returns on equity.
And I’ve never actually seen a company do that. And I’ve been investing for close to 30 years. There’s always some sort of decline. It’s that fade rate. And you just have to figure out when it’s gonna happen. And there are occasional that come in that can reinvent itself. But a lot of them don’t. So the expensive, to your point, got very expensive.
And then to your question about where the end valuation is, well, it depends how much risk you’d like to take. Because I could find you a nice Turkish bank or…
Meb: I’m in.
Sarah: That’s like a year ago. We could have talked oil and gas stocks. And I think that would have been the end of the podcast. But there’s always something cheap, but the question is how much risk you’re willing to take to own it and how long is your time frame. We’re always looking for about… So we wanted…our portfolios are a combination of what I call ballast. A part of the portfolio is there because the risk scores are so low than our risk-adjusted return basis, we don’t need a lot of return.
But we know in an extreme environment, this is also something that our quant colleagues measure for us. They show us in a bear market scenario what stocks in the portfolio would end up being…would hold value and would end up outperforming, most likely given their past. Those are the ones that we have to make sure we have a good dose of in the portfolio, the stocks that are likely to be very low risk in a market sell-off, even though it had been a long time since we’d seen one.
And as of the end of last year, I had clients who didn’t think that volatility was ever coming back, which I found particularly remarkable, but it always does. And those now are located…we have a lot of them in the healthcare sector and in telecommunications. They have high yields. They’re large cap pharma, or they’re the large mobile telephony companies. You wouldn’t run home and buy them. They’re not exciting stocks. But they’re very stable. And especially denominated in yen or in South Korean won, they don’t really correlate closely to the rest of the portfolio. So they provided really big dose of risk reduction.
And then on the more exciting return side are the smattering of across all sectors of companies are in the process of what we call self-help. Now that sounds tragic, but all that means is their management and all that new management are restructuring the business. There’s something went wrong operationally, and there may have been…an activist investor may have stepped in and rattled the cage of management and said, “You’ve really got to fix this.” And we at Causeway, we write letters with management. We demand the companies execute better so that our clients get paid for being so patient. Those are distributed across the industry spectrum.
The 101 is probably most legendary because we went into an absolute battle with them, and it went…paid off in spades. The Dutch paints and coatings company, AkzoNobel, they got an ADR but it’s primarily listed in the Netherlands. And they’re especially chemical companies, so in the industrial sector, and they produce decorative paints and the sort of stuff that goes on one’s walls as well as the coating on the bottoms of ships and a whole lot of other similar products. And they were just not coming anywhere near in terms of profitability to their U.S. peers. So we put quite a bit of pressure on management. And much to our delight, an activist investor stepped in as well and recognised the opportunity.
And then, interestingly, PPG Industries in the U.S. made a bid for the company. And it’s really quite extraordinary, the management wouldn’t entertain the bid, wouldn’t even engage. So we got very involved. And we’re out in the media talking about this. But I think it’s a really good example. If you want your company to engage in the type of self-help that’s needed to bring those profit margins where they should be, make them industry standard and not substandard, and for companies to take advantage of all revenue-enhancing opportunities. You have to push management sometimes, especially outside the U.S., where shareholders may have a little less in the way of influence, or there may be other more national reasons why a company behaves the way it does.
But that all worked out very well for our clients. And we look for those opportunities over and over again. Because for every company that’s outperforming, there’s some dud that isn’t. And as long as the balance sheet is solid and the company has what we consider superior financial strength to its peer group, to the others in its industry, then we think those are very ripe for Causeway investment and quite a candid discussion with the management about the improvements we’re anticipating.
Meb: To go through this process, I imagine this combination of kind of bottom-up and top-down and everything in between and quant work and fundamental. It’s funny. It reminds me, I remember being a younger investor and reading the Jim Rogers books, what was it, “Adventure Capitalist,” an investment biker about driving and biking all around the world and looking at these fun companies. And I said, “Man, well, that sounds like a dream job.”
And so as you’ve kind of chatted with all these managements and been kind of around the world, are there any areas in particular, I know you do a recurring series on Bloomy called “Where to Invest $10000 Right Now”, are there any regions, is it Europe, or is it certain countries like Japan, maybe you love the U.S., are there any areas that you think are particularly ripe for opportunity right now? And same question flips, are there any areas you think people should really avoid?
Sarah: I would say any one geography stands out, maybe with the exception to U.K., and that’s their own darn fault. From June of 2016, when the Brits decided to vote to leave the EU and that incredible display of requisite referendum confusion, the market has been a tough place. Even though in general, the U.K. market, when the pound sterling devalued versus the U.S. dollar in the wake of that referendum, the market looked like it went up. But when you get beyond the very largest cap companies there, the more indigenous U.K. companies, were treated pretty badly by investors.
So that we went through a period of about a year and a half where I’d heard a lot of U.K. companies that were just left for dead. And I think that’s a good example. We were looking there and found several, and they have paid off. But now some of the larger cap companies, they’re sort of languishing. And we’re not exactly sure why. I don’t think it’s a U.K. reason as much as it’s a coincidence or they happened to be listed there, some multinational companies.
And one I’ll mention in particular, British American Tobacco or BAT, sold off heavily when Philip Morris and Altria both admitted they’re having a tougher time than market had anticipated in heat-not-burn product, these alternatives to typical tobacco cigarettes. And it was a shame. Because British American Tobacco is so well-managed. My colleague [inaudible 00:23:00], who covers this stock, who looks after all the consumer staples for us, was just amazed to see the D rating. It’s like the last three years of earnings growth wiped out of the stock. And its primary listing is the U.K. and it was sort of endemic of…
I think investors were just not interested. They didn’t want anything to do with what they anticipated with structural change with the industry seemingly moving away from the tar-related, health-threatening cigarettes to something that might not be as addicting and might not be as lucrative. And we completely disagree with that. And that still, even though the stocks were covered from where it was a couple of months ago, it was one of the worst holdings we had year to date because we’ve a large weight in it but one of the most promising outlooks.
But we rarely see companies who can deliver 8% to 10% annualised earnings growth through just very savvy marketing their own procedures as well as knowing which markets to go after. And we like the idea that the change is one that’s more helpful, less harmful. But what was happening to their peers didn’t seem like the right read across for BAT.
And so just to…I want to give you an example of…a lot of what we’re finding is opportunistic. And it’s not like we’re buying all tobaccos or all U.K. I can tell you a story after story of these one-offs. But when you put them all together, that makes up a really good portfolio. And that’s another reason why if there’s a more idiosyncratic reason why we’re interested rather than we’re just buying value factors, which you could go out, your listeners could go out and do that cheaply, but that’s one of the reasons why active fees get paid. Because we’re actively looking for every one of these unique situations.
Meb: I think that’s a great example. I’m curious as you move east a little bit, you guys have a paper on your website talking about China. And there’s been a lot, and the media, certainly a lot of investor interest, China has kind of been all over the place, their equity markets over the past 15 years. But talking about the inclusion of China into a lot of the new indices, simply MSCI, what’s y’all’s general thoughts on China? Are you pretty bullish on the region as a whole, or are you cautious, or you still apply the same lens you do kind of with the rest of the portfolio, which is kind of the value-add boots-on-the-ground quant plus? What’s your thoughts there?
Sarah: More than two-year time frame, we’re not bullish. We’re wildly bullish about China. And maybe that’s more me than the rest of the team. But I look at it as the Chinese market will continue to open barring some disasters I’m not anticipating. But it’s not necessarily the healthiest country in terms of its sovereign debt levels, but it has plenty of competition for overextended, along with the U.S. and Japan and parts of Europe like Italy. So I can’t blame them for having a bit of debt in the economy. Having a closed capital account makes it all rather tricky, but the Chinese have done a reasonably good job.
And, again barring some calamitous situation, we believe that the intent by Beijing is to continue in an equitable way to open up that economy. And, ultimately, at some point in time, it may be a decade from now, the currency will be convertible, the RMB will be one that it’d just go out and hold and freely exchange and trade. But between now and then, the small steps that are taken are opening up the domestic stock market. You hinted about that.
There’s 3,000 stocks and trade in China and the Shanghai and Shenzhen Stock Exchanges. Maybe 2,000 of those are investable, where you would actually not think you’re just pouring money down the drain. And of those, there are hundreds that are being introduced by MSCI, the big index creator, to go into the broader benchmarks. I think 230 between this past June and September of 2018, and hundreds more after that. They just keep coming. It’s like planes coming in for a landing. You just can’t see the end of it.
And what’s amazing is these companies aren’t sort of fly-by-night, sketchy. Some of them very legitimate. They’ve got those we’ve all heard of, the large, you know, what I would call leviathans with the Tencents and the Alibabas. But if you go several layers beneath that, you’ll find world-class biotechnology companies and companies in education and a whole range of fields, transportation, etc., that are $5-billion, $10-billion, $15-billion, $20-billion market cap companies that only trade in China. And I think that’s what’s so thrilling is they haven’t even been unveiled to the rest of the world. And they’re coming. We’re not alone. I have no doubt that every investment manager worth his or her salt plus all the sell-side research, were scrambling to cover that market because of its enormity and its impact.
Meb: You think that’s an area that you can get away with buying the broad index. You think that China, in any ways, you mentioned a lot of you get the good and the bad is you’ve heard a lot of stories over the years certainly of challenging reporting and governance. Is that something you think that, as far as having active on the ground, is particularly helpful?
Sarah: Helpful. I’d say it’s essential. I wouldn’t dream of owning an index product in China. Not a chance. Certainly not of the A shares. The H shares, the stocks the trade on the H for Hong Kong, on Hong Kong Stock Exchange, they’ve been around for a while. And, I mean, that would be a conceivable passive investment. But as for the As, you’ll be like going to Vegas and putting on a blindfold and standing there at the tables, I mean, kind of pointless. There are plenty of bad with the good. And there’s no way around it. It’s meeting after meeting with managements and asking the questions.
We have a corporate governance template. What the heck is that you ask? That’s a series of questions to ascertain whether or not corporate governance, the way a company governs itself to protect its shareholders, is at a standard that we believe will be beneficial for our clients. That all comes from our quant colleagues. They’ve tested these questions and the resulting answers. And we take that when we meet with managements. And the Chinese A share companies, they cover the whole gamut from very shareholder-focused, in other words, they would return surplus capital to shareholders through greater dividend paths, or they’d repurchase shares, or maybe they’d do both, to those that haven’t any idea why they should be bothered with shareholders.
And the latter would not be a good idea. Like, those companies need to go through a whole series of…they need to mature. They need to learn that if they wanna access the capital markets, at least the equity markets, they have to treat shareholders well. I have no doubt that’s part of the reason why the Chinese government is so interested in opening up that market. It’s in part to help the overall domestic Chinese market mature because of the surplus savings trapped within China needs to go somewhere that’s not a casino, where managements are running the businesses efficiently and for shareholders.
Meb: From someone who’s never been to China…shame on me. I need to get a ticket over there. That’s on my…high on my to-do list. I’ve been in Hong Kong, but I don’t count that. I need to do a…do a trip.
One of the nice things about this conversation, which you actually don’t hear a lot with traditional managers is your kind of continued focus and discussion of risk. And there was a quote on your website, or where you guys, your group, talks about risk, and there’s something called the RiskLens. Is that something like the Snapchat or Google Glasses you can put on and have a view of what stocks are risky and everything else? Talk to us a little bit about what that kind of risk means to you and how you interpret it?
Sarah: Well, RiskLens is one of the primary products within our Causeway analytics group. So we have a group run by my colleague Seung Han that’s designed to give clients something in addition to just investment performance. In these days of fee pressure and concern about sustainability of returns at excessive benchmarks, having another service that we offer clients that’s very synergistic with what we do, and the nuts and bolts behind RiskLens we use in all of our strategies.
But RiskLens itself is, it’s simply a tool for clients to see…for example, they can take all of the mutual funds that they anticipate using, or maybe just a few of them, and our RiskLens will show them all the complementary funds, and the substitute funds, we’ll show them, we think, uniquely, we’ll show them predictive active risk so they can see what the tracking error will likely be for these funds. They’ll get an idea of how these funds correlate with each other.
And then, interestingly, if a manager is true to style… If you, for example, went out and hired us, Causeway International Value Fund, you’d expect value. It seems reasonable if it’s in the title. And our RiskLens is able to disaggregate the systematic risk factors or the market risk factors within a performance stream for a fund. And we can show clients who use RiskLens whether or not value is actually in a value fund. We’ve seen several that actually don’t have any, that seemed to have cheated and have quite a little bit of growth factor in them instead.
And clients have been so delighted with this. Because we’re offering this to them as…it’s just one of the services that we have here, and they get this window and this additional insight and enlightenment into… If you think about it, if you have several funds, all of a sudden you have this portfolio of funds so that each of them, they have these unique characteristics. But when you blend them altogether, what do you have?
And, again, it’s no more complex than just statistics and some formulas. It’s just how we format it and interpret it for clients and give them an idea looking forward of what to expect that I think they appreciate in particular. But, again, the mechanics of that are…that risk model that underpins it are what we use every day to manage our portfolios. Because every stock we have at Causeway fundamentally has something called a marginal contribution to risk. If this conversation gets any more exciting, I’m gonna fall out the window.
Meb: My audience loves this stuff. They’re gonna eat this up. If I love it, then that means they love it.
Sarah: [crosstalk 00:33:20] I can’t dress it up any more than it is. I just can’t. But the marginal contribution to risk is really important. Because when I talked about risk-adjusted return, it’s the marginal contribution to risk or the incremental amount of prospective volatility, that stock will add to our existing portfolio, that’s the risk score right there. That’s what it is. And it comes from our own proprietary multi-factor risk model. It’s the same model that RiskLens was built on, and it’s the same model we use for international equity, for global equity, and for emerging market equity.
And so we have to get it right. If we think we would like to add a stock to the portfolio, and it turns out that stock is bringing risk that we already have in the portfolio, the risk score will be very high. As a result, the stock won’t rank very well because it’s ranked on a risk-adjusted return. So we might have to buy something else or hold less of it.
And the converse is true, too. If we find some stuff that’s very diversifying and has very low risk score, it will be much easier for us to own that stuff, assuming it has enough return, because it’ll rank well. That’s the whole secret sauce to Causeway right there.
Meb: It only took us 45 minutes to get there. But it’s actually really interesting…
Sarah: That’s why you’re editing, right?
Meb: I should just start every conversation with “What’s your secret sauce?” No, it’s interesting because it’s particularly important. There’s so much marketing that goes on in our world. And I’ll give you two quick examples. I mean, it’s the difference between people, what they say and what they do. So, for example, there was an option fund that just blew up in February that lost 95%. And the name of the fund was called Preservation and Growth.
And then the more recent example is that you’ve had a lot of these, the rush into dividend, high-dividend yielding securities over this past cycle because everyone is looking for yield. And you have a number of these that are called dividend and value or value yield or value income. And then you go type the holdings into…Morningstar has probably a watered-down version of some of the analytics, but you can type it in and it’ll show you that, actually, what you’re getting is a lower yield in the S&P but consistently more expensive stocks. So the marketing doesn’t always sync up with what they’re actually getting.
So as you think about risk, you know, other than saying, “All right, you guys go buy a bunch of Causeway funds.” To the average listener, what do you think the biggest mistakes, particularly with risk, that people make? Is it buying these kind of undiversified portfolios, or constructing them sort of sub-optimally? Is it some other sort of risks that having managed money for a while that you see people consistently making that you think is unavoidable, or anything come to mind?
Sarah: I’d say that litmus test question is do you have a risk model or not. Because the no-risk-model people are at those portfolios in the category of you don’t really know what you’re getting. If they’re not constructed with a risk model, then they could be very concentrated, the risk could be very concentrated. And why do you care? Because that means the returns can be very volatile and not consistent, and that means you might be waking up at 3 a.m. in a cold sweat versus those managed with a risk model.
But a risk model itself is not a panacea. Like, why we at Causeway put fundamental and quant professionals on the same floor, the same office, and have a joint portfolio and management meeting, we’re kind of at each other’s throats sometimes. Because our quant colleagues may put a very high risk score in a stock, but we know that company had made a major acquisition or done something transformative to change its business so that the last eight years of history, of its share price history, may not be at all indicative of how it will trade in the future. It literally has changed its stripes.
And quant models can’t pick up on that. They don’t know that. They just use the eight-year estimation window because that’s what they do. At least that’s what ours does. And that’ll be true with any off-the-shelf quant model one could obtain. So that’s why there has to be a fundamental check. But I think that’s one of the mistakes others make is they just use these models blindly.
You know, I think the banks are a great example. Like, 308, they were leverage monsters, huge leverage, and very skinny amounts of capital. And then especially in other…outside of the U.S. even, parts of Asia and parts of Europe, the domestic regulators, the bank regulators required them to triple the level of their capital. And all of a sudden they became kind of fat in terms of their capital levels.
But it changed their risk profile dramatically. And using the eight-year history that was very heavily influenced by the global financial crisis wasn’t really appropriate. And we had to make adjustments and shorten the estimation window. And we looked at the futures markets. We did everything we could to figure out under a new capital regime, with a new set of regulations and pickings, so a lot of the proprietary trading off their books, what were these animals? How should we think about them in terms of risk?
Meb: I’d love to keep you all day. I wanna wind down with a few more questions. There’s a slight pivot to the right, where I notice you’re on the board of something called Girls Who Invest. I would love to hear a little bit about what that’s all about.
Sarah: Girls Who Invest was started about four years ago by a former Causeway client, the former head of equities at the City of New York’s Pension Plan, and her name is Seema Hingorani. And she had complained to many of us, as her asset managers, of where were the women. She wasn’t seeing enough women in the ranks of portfolio manager and senior research analyst. So she took it upon herself, with a lot of support from all of us, her admirers and her advisory board, to create Girls Who Invest.
And the organisation has been affiliated with, or has partnered with the Wharton campus to educate these young college women who apply. The first summer there were 30 of them. That was three years ago, and then 60 this summer. There are over 100. They get a sort of mini MBA and weeks of finance and spreadsheet modeling type instructions and accounting.
And then this summer, University of Notre Dame also kicked in a campus program. All of this is free. And then the women have internships. And so as part of the advisory board, I’ve had a chance to help find more participants and get more investment managers that engage in this program. Because we’d like it to be worldwide. Right now we’re just happy with nationwide.
And there colleges and universities, from public to private, from the top level down to the lower level and everything in the middle, the idea is to reach into every possible chasm of this country to find these women, they are freshman and sophomore, in college, who would never have heard of the asset management industry, whether it be equities, fixed income, real estate, and lure them in and so that they can tell their friends. They can go back after they do a summer with Girls Who Invest.
Like, our first, three years ago, our first intern, she went on to get an internship the following summer. So she was with us the summer after her freshman year. She was 19. We would never hire anybody that young if it weren’t for this program. We taught her as much as we could. She went to work for another investment manager the following summer. And then, again, by the time she graduated, she was so hirable in the asset management industry. And if she chooses to go to business school, she’ll be even…her human capital will go up even higher.
But we had to do this. There was no other way but to seed the pipeline. Because the MBA classes that already have a minority of women, they were going to technology or they’re going somewhere else. And this is a fantastic industry for women. And it’s very difficult to provide the types of excellent…or the excellent performance clients demand if we don’t have a very diverse group of investment professionals. And gender is certainly one of the important criteria to define diversity.
Meb: There’s a lot of academic research that supports that women are, in general, are better portfolio managers anyway. So it’s, you know, it’s funny. It’s something I tweeted about. I had publicly, a couple months ago, I was actually really struggling with this topic, where I said, you know, I don’t have any answers, but I said I struggle, you know. There’s really a lack of, particularly in the quant world, so that’s, like, probably even more so, there’s certainly a lack of female representation. I don’t have any answers. I don’t really know what to do about it. Part of me spends the time being depressed about it. Part of me just says, “I don’t know how to solve it.”
I think it’s almost part of the whole challenge of the behaviour and education gap in investing in general. And not just investing. I mean, personal finance, too, has long been something that we really struggle with. And it’s not something people teach in high school or, you know. And often, in some colleges, they do if you’re in the finance discipline. So I don’t have any good answers, but I’m glad to see someone’s tackling it. Very cool. A pat on the back to you, guys.
We’ve held you long enough. We’ve got to start winding down. There’s a question we ask everyone that’s been on the podcast in the past year, and that is, if you could look back in your career, and even pre-career, whatever it may have been, is there something that sticks out as the most memorable investment for you personally or a trade? It could be good. It could be bad. It could be a stock. It could be something. Whatever. Is there anything that kind of pops to mind as the most memorable investment you’ve ever made?
Sarah: Oh, yeah. And I don’t even have to hesitate on that one. That was starting Causeway in 2001. It was terrifying. I didn’t understand cash burn until I was in the middle of it, on fire. It takes so much courage to walk away from a well-paying, high-paying job and people who are counting on you. And even though California is very employee-centric, you can’t take any IP from your former employer, you can’t take client list, you can’t take employees. So you take a tremendous amount of risk.
But you just know, because you’ve thought about this for months, quarters, years, and you’ve looked at best practises from other firms and figured out how to avoid the worst ones, how to pull it off. But it’s still, at the time, it’s terrifying and exciting. I’ve never made an investment like that before. I don’t think I ever will again.
We worked out of the office of our IT provider. We didn’t have office space. We just got up, had the plan in hand, and left. And you just have to know because you’ve developed client relationships that somebody will follow and you’ll be able to turn the lights on. But it’s terrifying.
Meb: What was the runway like? It’s interesting for someone who can relate very, very directly to your comments about cash burn and starting a company. We often tell people, the young people listening to this podcast, you know, they’re often, they see the pot of gold at the end of the rainbow, and they think money management sounds like so much fun. I wanna be like Axelrod on “Billions.” And I’m gonna be a hedge fund manager. And I’m gonna drive fancy cars. But we often say managing money and the business of managing money is not the same thing. And the challenges of the business of managing money is a huge pain in the butt.
What was kind of the on-ramp? Was it pretty rocky in the first couple of years, or was it actually pretty smooth once you guys decided to go out on your own and ramp up?
Sarah: In addition to lining up all the potential adversarial forces in your favour so that… We had a really good IT platform. We started with great expertise there, we had great expertise in legal. We had great expertise across the administrative functions of the firm. But the investment performance had to be good. It had to be good for the first several years. Otherwise, we would never have made it.
And we just launched at a really good time when the global TMT bubble, the telecommunications, media, and technology bubble had burst. And that was March of 2000. And by June of 2001, value was just beginning to turn. And that’s all we had. All we had at the time was international. In fact, we started with global, but we didn’t even have quant strategies back then. So we were very concentrated in one area, and we had to deliver superior performance or we wouldn’t have attracted our former clients, not to mention new ones. So that was the part that had me holding my breath.
The rest of it we had built methodically. And that was just money. The rest we could buy. And we had to bring in an outside investor to help feed the business, but the performance, it was all up to us. And it could have been some further ill wind that kept the value manager down. And thankfully, it turned out to be a tailwind.
Meb: It reminds me of the old Julian Robertson quote when a young manager was saying, “Hey, do you have any advice for me starting out with my new fund?” And he says, “Yeah.” Basically, get lucky and have great performance, because that helps a lot in the beginning. And so…
Sarah: That’s important.
Meb: Yeah. Sarah, this has been an absolute delight. Thank you so much for taking the time today. Where can people, if they wanna follow your investments, your writings, anything else, where do people find out more info?
Sarah: Well, the Causeway Capital website is a good place. And we’re also on LinkedIn. Finally, our compliance capitulated and we are posting some of our insights there. So those would be the two best places.
Meb: Sarah, thanks so much for taking the time today.
Sarah: Yeah, Meb, I hope you make it to China soon.
Meb: All right. Listeners, it’s been a blast. You can find the show notes. We’ll post links to some of Sarah’s pieces and some other presentation…all that good, fun stuff on the blog, mebfaber.com/podcast. You can find over 100 back episodes now. We love to hear from you guys. Send us feedback at the mebfabershow.com. If you really like it, leave us a review. Thanks for listening, friends, and good investing.